CFA Level III Outline-Notes (2010)

CFA Level III Notes Mark E. Oblad For June 2010 Test Reading 1: Code of Ethics and Standards of Professional Conduct Standards of Practice Handbook  CFA Institute Professional Conduct Program: 2 basic principles: 1. fair process; 2. confidentiality Board of Governors  Professional Conduct Program  Disciplinary Review Committee: responsible for  enforcement of code and standards CFA Institute Designated Officer, Professional Conduct Staff: conduct inquiries: o 1. self-disclosures, 2. written complaints, 3. media, 4. exam proctors o 1. interview subject, 2. interview complainant, 3. collect docs o  No disciplinary sanction; cautionary letters; continue proceedings o Designated Officer proposes discipline; if rejected then panel of CF A Institute members • •

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Code and Standards: encourages firms to also adopt •

Code of Ethics I. Act with with inte integri grity, ty, compet competence ence,, dili diligenc gence, e, resp respect ect,, and and in in an ethica ethicall mann manner er wit with h the the publ public, ic, client clients, s,  prospective clients, employers, employees, colleagues in the investment profession, and o ther participants in the global capital markets. II. Place Place integr integrity ity of of the inves investm tment ent profe professi ssion on and the the intere interests sts of clien clients ts above above their their own own person personal al inter interest ests. s. III. III. Use reaso reasonabl nablee care and exerc exercise ise indepe independen ndentt profess profession ional al judgme judgment nt when condu conducti cting ng investm investment ent analys analysis, is, making investment recommendations, taking investment actions, and engaging in other professional activities. IV. Practi Practice ce and encour encourage age other otherss to practi practice ce in a profes professio sional nal and and ethical ethical manne mannerr that will will refl reflect ect credi creditt on themselves and the profession. V. Prom Promot otee the the inte integr grit ity y of, of, and and uphol uphold d the the rule ruless gove govern rnin ing, g, cap capit ital al mar marke kets ts.. VI. Mainta Maintain in and impro improve ve their their profe professi ssiona onall compete competence nce and stri strive ve to mainta maintain in and impro improve ve the compe competen tence ce of  other investment professionals. Standards of Prof’l Conduct (7 items) I. Prof Profes esssiona ionallism ism a. Know Knowlledge edge of Law Law  b. Indepe Independen ndence ce and Object Objectivi ivity ty c. Misr Misrep epre rese sent ntat atio ion n d. Misconduc duct II. Integr Integrity ity of Capi Capital tal Mark Markets ets a. Mate Materi rial al Nonp Nonpubl ublic ic info info  b. Mark Market et Mani Manipul pulat atio ion n III. Duties Duties to Clients Clients a. Lo Loya yalt lty, y, Pru Prude dence nce,, and and Care Care  b.  b. Fair Fair Deal Dealiing c. Suit uitabil bility d. Perf Perfor orma manc ncee Present Presentat atio ion n e. Preser Preservat vation ion of Confid Confident ential iality ity IV. Duties Duties to Employers Employers a. Loyalty 40963581.doc 1 of 114

 b. Additio Additional nal Comp Comp Arrange Arrangemen ments ts c. Respon Responsib sibil iliti ities es of Supervi Supervisor sorss V. Investment Investment Analysis Analysis,, Recommendati Recommendations, ons, and Actions Actions a. Dili Dilige gence nce and and Reas Reason onab able le Basi Basiss  b. Comm’n Comm’n w/ Clie Clients nts and and Prospect Prospective ive Clien Clients ts c. Reco Record rd Rete Retent ntio ion n VI. Conflicts Conflicts of Interest Interest a. Disc Disclo losu sure re of Conf Confli lict ctss  b. Prio Priori rity ty of Tra Trans nsact actio ions ns c. Refe Referrral ral Fees Fees VII. VII. Respon Responsib sibil iliti ities es as a CFA CFA Insti Institut tutee Member Member or CFA CFA Candi Candidat datee a. Conduct Conduct as as Member Memberss and Candid Candidate atess in the CFA CFA Program Program  b. Reference Reference to CFA CFA Institut Institute, e, the CFA Designatio Designation, n, and the CFA Program Program Reading 6: Asset Manager Code of Professional Conduct: Intended to be adopted at firm level General Principals of Conduct: 1. Act in in a prof’l prof’l and ethic ethical al manne mannerr at all all times times 2. Act Act for for bene benefi fitt of cli clien ents ts 3. Act w/ indep independ endence ence and object objectivi ivity ty 4. Act w/ w/ skill skill,, compet competence ence,, and dili diligenc gencee 5. Communicate Communicate w/ clients clients in a timely timely and accurate accurate manner  manner  6. Uphold Uphold rule ruless governi governing ng capit capital al marke markets ts Asset Manager Code of Professional Conduct (6 parts): A. Lo Loya yalt lty y to Clie Client ntss 1. Place Place client client inter interest estss before before thei theirr own 2. Preserve Preserve confidentia confidentiality lity of info info communicated communicated by clients clients w/I the the scope of the Manager-c Manager-client lient relationship 3. Refuse Refuse to participate participate in any busines businesss relationshi relationship p or accept any gift gift that could reasonabl reasonably y be expected to affect their independence, objectivity, or loyalty to clients B. Invest Investmen mentt Proces Processs and Acti Actions ons 1. Use reasonabl reasonablee care and prudent prudent judgment judgment when managin managing g client client assets assets 2. Not engage engage in practices practices designed designed to distort distort prices or artifi artificiall cially y inflate inflate trading trading volume w/ the intent to mislead market participants 3. Deal fairly fairly and objectiv objectively ely w/ all clients clients when providin providing g investment investment info, making making investment investment recommendations, or taking investment action 4. Have a reasonable reasonable and and adequate adequate basis basis for for investm investment ent decision decisionss 5. When managing managing a portfolio portfolio or pooled pooled fund according according to a specific specific mandate, mandate, strategy, strategy, or style: style: a) Only take take investment investment actions actions that are consist consistent ent w/ the stated stated objectives objectives and constrain constraints ts of that portfolio or fund  b) Provide Provide adequate adequate disclosures disclosures and info info so investors investors can consider consider whether whether any proposed proposed changes in the investment style or strategy meet their investment needs 6. When managing managing separate separate accounts accounts and and before provid providing ing investment investment advice advice or taking taking investment action on behalf of client: a) Evaluate Evaluate and understand understand the client’ client’ss investment investment objectives, objectives, tolerance tolerance for risk, risk, time time horizon, liquidity needs, any other unique circumstances (including tax considerations, legal or regulatory constraints, etc.), and any other relevant info that would affect investment policy.  b) Determine Determine that an investm investment ent is suitable suitable to a client’s client’s financial financial situati situation on 40963581.doc 2 of 114

C. Tradin ding 1. Not act, act, or cause others others to act, act, on material material nonpubli nonpublicc info that that could affect affect the the value of a  publicly traded investment 2. Give priorit priority y to investment investmentss made on behalf behalf of the client client over those those that that benefit benefit their own own interests 3. Use commissi commissions ons generated generated from client client trades trades only to pay for for investment investment-relat -related ed products products or  services that directly assist the Manager in its investment decision-making process and not in the management of the firm 4. Maximize Maximize client client portfolio portfolio value value by seeking best best execution execution for all client client transacti transactions ons 5. Establish Establish policies policies to to ensure fair fair and equitable equitable trade allocati allocation on among client client accounts accounts D. Compli Compliance ance and Support Support 1. Develop Develop and maintain maintain policies policies and procedures procedures to ensure ensure that their their activities activities comply comply w/ the  provisions of this Code and all applicable legal and regulatory requirements 2. Appoint Appoint a compliance compliance officer officer responsible responsible for for administeri administering ng the policies policies and procedures procedures and for investigating complaints regarding the conduct of the Manager or its personnel 3. Ensure Ensure portfolio portfolio info info provided provided to clients clients by the the Manager is is accurate accurate and complete complete and arrange for independent third-party confirmation or review of such info 4. Maintain Maintain records records for an appropri appropriate ate period period of time time in an easily easily accessible accessible format format 5. Employ Employ qualified qualified staff and and sufficient sufficient human human and technological technological resources resources to to thoroughly thoroughly investigate, analyze, implement, and monitor investment decisions and actions 6. Establish Establish a business-co business-continu ntinuity ity plan to address address disaster disaster recovery recovery or periodic disrupti disruptions ons of the financial market 7. (record (record retention retention recomme recommendatio ndation n is 6 yrs (as (as opposed opposed to 7 for individu individuals)) als)) E. Perfor Performan mance ce and Valuat Valuation ion 1. Present Present performan performance ce info that that is fair, accurat accurate, e, relevant, relevant, timely timely,, and complete. complete. Managers Managers must not misrepresent the performance of individual portfolios or of their firm 2. Use fair fair market prices prices to value client client holdings holdings and apply, apply, in good faith, faith, methods to determi determine ne the fair value of any securities for which no readily available, independent, third-party market quotation is available F. Disc Disclo lossures ures 1. Communicate Communicate w/ client clientss on an ongoing ongoing and timely timely basis 2. Ensure Ensure that disclosur disclosures es are truthful, truthful, accurate accurate,, complete, complete, and understandabl understandablee and are presented presented in a format that communicates the info effectively 3. Include Include any material material facts facts when making disclos disclosures ures or providing providing info info to clients clients regarding regarding themselves, their personnel, investments, or the investment process 4. Disc Disclo lose se the the fol follo lowi wing ng:: a) Conflicts Conflicts of interes interestt generated generated by any relationsh relationships ips w/ brokers brokers or other entitie entities, s, other  client accounts, fee structures, or other matters  b) Regulatory Regulatory or discipl disciplinary inary action action taken against against the Manager Manager or its personnel personnel related related to  professional conduct c) The investment investment process, process, including including info regarding regarding lockup periods, periods, strategi strategies, es, risk factors, factors, and use of derivatives and leverage. d) Management Management fees and other other investment investment costs costs charged to investor investors, s, including including what costs costs are included in the fees and the methodologies for determining fees and costs. e) The amount amount of any soft soft or bundled bundled commissi commissions, ons, the goods goods and/or and/or services services received received in return, and how those goods and/or services benefit the client f) The performa performance nce of clients clients’’ investment investmentss on a regular regular and timel timely y basis basis g) Valuation Valuation methods methods used to to make investme investment nt decisions decisions and value value client client holdings holdings h) Shareh Sharehold older er voting voting polici policies es i) Trad Tradee all alloc ocat atio ion n pol polic icie iess  j) Result Resultss of the the review review or or audit audit of the the fund fund or accoun accountt 40963581.doc 3 of 114

k) Significan Significantt personnel personnel or organization organizational al changes that that have occurred occurred at the Manager  Manager  Reading 7: Heuristic-Driven Bias: The First Theme: I.

Heuristic-Driven Bi Bias: 4 elements a. People develop develop general general princi principles ples as they find find things things out for themsel themselves ves  b. They rely rely on heuristics heuristics,, rules of thumb, thumb, to draw inference inferencess from the info info at their disposal disposal c. People are are susceptibl susceptiblee to particular particular errors errors b/c b/c the heuristi heuristics cs they use use are imperfect imperfect d. People actually actually commit commit errors errors in particular particular situations situations • •

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Availability Heuristic: back-of-the envelope calculation based on readily available info Representativeness: to view something as a stereo type and make predictions therefrom i. Regression Regression to the the mean mean – counter counter to represe representati ntativeness veness;; ii. Gambler’s Gambler’s Fallacy Fallacy – to predict predict the the outcome outcome of an independentl independently y probable probable event as a dependently probable event to fit the aggregate probability distribution;  the law of large numbers does not apply to a small sample. Overconfidence: setting too narrow of confidence bands; get surprised frequently Anchoring-and-Adjustment: to be influenced by and toward the past observation or a number you’re working from i. Underreact: Underreact: when when you don’t don’t know how to to incorporate incorporate the new new informatio information, n, you stay stay with your  your   past belief  Aversion to Ambiguity: fear of the unknown; proclivity to choose 100% probably $1k over 50%  probably $2k and 50% probably $0.

Such heuristics influence: analysts’ earnings forecasts, investors’ evaluation of mutual fund performance, co rporate takeover decisions and the type of portfolios selected by both individual and institutional investors. Other heuristics: excessive optimism, illusion of validity, hindsight bias, illusion of control and self-attribution error. Reading 8: Frame Dependence: the Second Theme Frame: form used to describe a decision problem; traditionally (incorrectly) assumed to be transparent Frame dependence: equivalent frames may be opaque causing people to feel differently when faced with different but equivalent frames; “the way people behave depends on the way that their decision problems are framed.” cognitive: the way people organize info the way people feel as they register the info i. “house money” money” effect: effect: more more likely likely to take a gamble gamble if you you feel like like you just just got ahead. ahead. • •

Loss aversion: loss has about 2.5x the impact of a gain of the same magnitude [on emotions] “get-evenitis” Concurrent decisions: if lose in first game, may behave d ifferently in second game for chance to get even. Mental accounts: failure to see two decision problems p roblems together as a concurrent package. Hedonic editing: people prefer some frames to others; to choose frames that obscure losses i. Prefer “transfer “transfer your assets” assets” to “close “close account account at a loss” loss” ii. People are not uniform uniform in in their tolerance tolerance for risk; risk; some some appear to tolerate tolerate risk risk more readily readily when they face the prospect of a loss than when they do not iii. People do not net two two gains: they they savor them them separately separately (added (added attractio attraction n to gambling) gambling) • •

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iv. People are incapabl incapablee of netting out moderat moderately ely sized sized losses of simil similar ar magnitudes magnitudes (shy away away from gambling) Prospect theory Emotional frames: self-control: controlling emotions; people put rules in place to gu ard against temptation: “don’t dip into capital” and view dividends not as capital. regret minimization: emotion experienced for not having made the right decision; pain of loss and feeling responsible for loss; may cause people to prefer d ividends to finance consumption rather than capital b/c of the regret from the (frame) of the missed capital appreciation money illusion: people think of money in nominal n ominal values (and disregard discounting for inflation) •

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Reading 9: Inefficient Markets: The Third Theme De Bondt-Thaler winner-loser effect: investors who rely on representativeness heuristic become overly pessimistic about past losers and overly optimistic about past winners causing price inefficiency Conservativism due to anchoring-and-adjustment: results in positive earnings surprises to be followed by positive surprises and vice versa (post-earnings-announcement drift). Frame dependence: loss aversion causes c auses investors to shy away from stock resulting in relatively high returns (mental accounting). Myopic loss aversion: too short of evaluation horizons resulting in individual investors’ historical reluctance to hold stocks. House-Money Effect: results in more risk taking after runups and vice versa. Overconfidence: 1. Investors take bad bets b/c they fail to realize that they are at an informational disadvantage; 2. investors trade more frequently than is prudent Reading 10: Portfolios, Pyramids, Emotions, and Biases Fear induces an investor to focus on events that are especially unfavorable; hope induces to focus on events that are favorable. Specific goals: aspire to purchase home, fund college, comfortable retirement Fear transforms into regret. Layered pyramid: bottom: securities to provide security (money market; CDs); securities for specific goals (bonds); top are securities for appreciation (stock, real estate). layers can be thought of as mental accounts  priorities are the mental account associated w/ bottom layer  • •

Use mean-variance to determine portfolio; provide investor w/ probability of achieving at least aspiration level, by which the investor will evaluate in terms of fear, hope and aspiration. Security design: layers can explain design of securities: guaranteed principal w/ possibility of upside. 40963581.doc 5 of 114

Portfolio selection: 1. investors excessively optimistic about their portfolio while not about the market; 2. overconfident: surprised by price changes; 3. price forecasts anchored by past performance; 4. underestimate beta. also investors discount diversification reject positive tradeoff b/w risk and return • •

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inadequate insurance coverage younger people systematically think less likely to experience bad ou tcomes and more likely to experience good outcomes failure to diversify excessive risk taking

Overconfidence: too much trading: investors who are high in desire for control and suffer from illusion of control are  prone to trade frequently.  believe can pick winners internet stocks and day trading: single young men trade more and in riskier companies, resulting in men earning 1.4% risk adjusted less return by one on e study and single men 2.3% less. Failure to diversify: even when assets other than stocks included i. Naïve diversif diversificat ication: ion: 1/n rule: rule: divide divide 401k contributio contribution n equally among among options in in plan. ii. Home bias: bias: bias toward toward U.S. U.S. stocks (aversi (aversion on toward toward ambiguity: ambiguity: fear) fear) •

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Reading 11: Investment Decision Making in Defined Contribution Pension Plans Bounded Rationality: limits on intelligence and time Bounded self-control: fail to do the apparent right thing Bounded self-interest; “myopic loss aversion”: seeking to avoid short-term losses, despite the long time horizon usually involved in planning for retirement Failure to diversify: “1/n diversification heuristic”: split contributions equally amongst the n funds on offer, w/ little regard to underlying asset composition of the funds. i. “endorsemen “endorsementt effect”: effect”: the entire entire selection selection of assets assets is seen as implicit implicit guidance guidance from from employer  employer  as to appropriate asset allocation strategy “too much choice”: negative relationship b/w # of funds on offer and employee participation Too much own-company stock; don’t realize it is riskier; preference to “invest in the familiar”/”home country bias”; also “endorsement effect” •

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Employer may paternalistically design plan to maximize chance that most appropriate options are taken: opt-out rather than opt-in; default contribution rates; default fund options an d range and nature of fund choice on offer; nature of info and advice UK: DB plans: group personal pension (GPP) and stakeholder plans; DC plans: occupational money purchase (OMP) more common that there is “too little choice” no “own-company stock” problem • •

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Reading 12: Global Equity Strategy: the Folly of Forecasting: Ignore All Economists, Strategists, and Analysts “Those who have knowledge don’t predict. Those who predict don’t have knowledge.” Economists seem to lag reality; inflation forecasts appear to be largely a function of past inflation rates: adaptive expectations. Overconfidence as Driver of Poor Forecasting: overconfident: surprised more often that they expect to be; “not well calibrated” experts more overconfident than lay people i. illusion illusion of knowledge: knowledge: we think we know know more more than everyone everyone else else ii. ii. illu illusi sion on of contr control ol explained as: ignorance: not knowing that overconfidence exists; arrogance: ego defense mechanism Those who are amongst the worst performers actually are the most overconfident “the skills needed to produce correct responses are virtually identical to those needed to evaluate the accuracy of one’s responses.” “top-down” approach: people start w/ a preconceived belief about their skills or abilities and use those  beliefs to estimate how well they will do at a specific task  Ego Defense Mechanism: i. “expertise “expertise thus may may not translate translate into into predictive predictive accuracy accuracy but it does transl translate ate into the ability ability to generate explanations for predictions that experts themselves find so compelling that the result is massive overconfidence.” ii. Conservatis Conservatism m bias: tendency tendency to hang on to views views too long and only only slowly slowly adjust; adjust; failure failure to slash probability after the outcome is known. iii. iii. 5 commo common n strat strategi egies/ es/def defens enses: es: “if only” defense: create a counterfactual; if certain event had occurred, or if original advice or analysis had been followed “ceteris paribus” defense: although advice or analysis was correct, something else occurred that blew off course “I was almost right” defense: event almost happened “it just hasn’t happened yet” defense: although the predicted outcome has not yet occurred, it will eventually come to pass “single prediction” defense: analysis is valid, but the act of forecasting was flawed: “everyone knows (or should know) that forecasting is pointless” iv. Anchoring: Anchoring: tendency tendency to to grab onto onto the irrele irrelevant vant when when faced w/ uncertainty uncertainty “little wonder that investors cling to forecasts, despite their uselessness.” • •

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Reading 13: Alpha Hunters and Beta Grazers Acute inefficiencies: discernible opportunities that can be exp loited by accessible arbitrages; surrounding uncertainties can be hedged or minimized; resolution occurs quickly. Chronic inefficiencies: tend to be less discernible, more ambiguous, more resistant to rapid resolution from available market forces, and generally longer tem in nature (arise from structural and behavioral sources: trading frictions, organizational barriers, imbalances in capital flows, valuation ambiguities, lack of catalysts for resolution, convoy or  herding behavior, artificial peer comparisons, rebalancing incon sistencies, compulsive confirmation seeking, filtering of conflicting data, misreading of market signals, inertia, formulaic action plans, and overly rigid “policy portfolios”)

Behavioral factors: convoy behavior, Bayesian rigidity, price-target revisionism, ebullience cycle 40963581.doc 7 of 114

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convoy behavior: herding behavior of o f institutional funds; i. "Compounding "Compounding consensu consensus": s": tendency tendency to seek seek the opinions opinions of other other "experts "experts"" who can confirm confirm one's own views Bayesian Rigidity: to relentlessly try to retain old views in the face of new information Price-Target Revisionism: price movements in predicted direction tend to be taken as confirmation of  wisdom, and the target is extended; to avoid: have plan to reduce positions as the original target is approached Ebullience Cycle: during up markets, investors inclined to hold on firmly to winning positions (shining examples of brilliance); in down: "unopened envelope" syndrome and propensity for inaction in the face of losing positions

Portfolio rebalancing behavior of holders, rebalancers, valuators and shifters holders: tend to leave envelopes unopened and positions unchanged in down markets rebalancers: investors who formulaically rebalance to policy portfolio allocation, usually institutions valuators: take positions based on whether market is ch eap or rich and expect exp ect reversal; also momentum shifters: making fundamental moves from one strategic stance to an other (usually individuals), after  event like loss of job • • • •

Market impact: holders out of game rebalancers have smoothing effect valuators: those who are contrarians and "reversionists" will act as moderators; momentum investors will have exacerbating effect shifters: exacerbate market movements • • •

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Beta investors: buy indexes; alpha investor: chip away at chronic inefficiencies and behavioral biases

Reading 14: Managing Individual Investor Portfolios Investor Characteristics: Situational Profiling: Source of Wealth: self-made investors have greater familiarity w/ risk taking, but high sense of control o Measure of Wealth: subjective nature of financial well-being; one portfolio may seem large to one and o small to another, affecting risk attitudes Stage of Life: o  Foundation: establishing base on which to create wealth: skill, establish business, education  Accumulation: earnings accelerate  Maintenance phase: maintaining desired lifestyle and financial security (usually retired); risk  tolerance decreases  Distribution phase: transfer wealth Psychological Profiling: aka personality typing; bridges differences b/w traditional finance (economic analysis of objective financial circumstances) and behavioral finance Traditional finance: investors assumed to 1. exhibit risk aversion, 2. hold rational expectations o (coherent, accurate and unbiased forecasters, reflecting all relevant info and learn from past mistakes) and 3. practice asset integration o Behavioral Finance: investors 1. exhibit loss aversion; 2. hold biased expectations; 3. practice asset segregation •

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loss aversion: prospect theory: investors place different weights on gains and losses; prefer an uncertain loss to a certain loss, but prefer certain gain to uncertain gain  biased expectations: cognitive errors and misplaced c onfidence in ability to assess future asset segregation: evaluate investment choices individually rather than in the aggregate resulting in the following assumptions for portfolio construction: asset pricing reflects both economic considerations, such as production costs and prices of substitutes, and subjective individual considerations, such as tastes and fears  portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer  reflects certain goals and constraints Personality Typing: 1. ad hoc review by investment advisor based on interviews and past investment activity; 2. client questionnaires Cautious Investors: strong need for financial security; demand low-volatility investments w/ little potential for loss of principal; overanalyze; easily persuaded but often do not seek professional advice Methodical Investors: relies on hard facts; undertake research; conservative; not emotionally attached to investments Spontaneous Investors: constantly readjusting; not experts; doubt all advice; overmanage; Individualist Investors: confident; work hard at info sources and reconcile  Decisions based primarily on  Decisions based primarily on feeling  thinking  Methodical Cautious Individualist Spontaneous •

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More risk averse  Less risk averse

Investment Policy Statement: return objectives: determined in connection w/ risk tolerance; return requirement vs. return desire; “total return” approach: seeks to identify a portfolio return that will meet investor’s objectives w/o o exceeding the portfolio’s risk tolerance or violating its investment constraints consider: inflation, taxes o risk objectives: ability and willingness; o ability: financial goals relative to resources and time frame; critical goals have low margin of error and reduce ability to have volatility willingness o Constraints: Liquidity: anticipated and unanticipated demands for cash distributions; liquidity affected by o transaction costs and price volatility; general liquidity requirements: ongoing expenses, emergency reserves, negative liquidity events; should identify illiquid holdings; o Time Horizon: 15-20 yrs is long; 3 to 15 is intermediate; single vs. multistage; stage of life; o Taxes: types: income taxes, gains taxes, wealth transfer tax, property tax; tax deferral; tax avoidance; tax reduction; wealth transfer taxes: transfer at death, early transfers  Capital gains tax = Price appreciation x CG tax rate x Turnover rate Legal and regulatory environment: personal trusts: revocable and irrevocable; Family foundation; o  jurisdiction: where taxed Unique circumstances: social and special purpose investing; assets legally restricted from sale, directed o  brokerage arrangements, and privacy concerns; assets held outside investment portfolio Investment policy statement outline: I. Background II. Return Objectives III. Risk To Tolerance •

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a. Ability  b.  b. Will illingn ingnes esss Constraints a. Liquidity  b.  b. Time Time Hor Horizon izon c. Taxes d. Legal Legal and Regula Regulator tory y Envi Environ ronmen mentt e. Uniq Unique ue Circ Circum umst stan ance cess

Asset Allocation: Selecting asset allocation: 1. determine asset allocations that meet investor’s return requirements o 2. Eliminate asset allocations that fail to meet quantitative risk objectives or other inconsistent w/ risk  o tolerance 3. Eliminate asset allocations that fail constraints o 4. Evaluate expected risk-adjusted performance and diversification attributes that remain; select most o rewarding Monte Carlo Simulation in Personal Retirement: provides a probability of meeting objectives estimate to assess risk  advantages: o  more accurately portrays risk-return tradeoff than deterministic approach  gives info on possible tradeoff b/w short-term risk and risk of not meeting long-term goal  can model portfolio changes from tax effects  well suited to model stochastic process and resulting alternative outcomes disadvantages o  relies on historical data  must evaluate performance of specific investments, not just asset classes, and adjust for fees  must account for tax consequences •

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Reading 15: Taxes and Private Wealth Management in a Global Context: Global tax structures: taxes on income: progressive or flat wealth-based taxes (property and on wealth transfers) consumption taxes (sales taxes; value added taxes) • • •

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Classification of Income Tax Regimes Regime 1 – Common Progressive Ordinary Tax Progressive Rate Structure Interest Income Some interest taxed

Dividends

Capital Gains

Example Countries

at favorable rates or  exempt Some dividends taxed at favorable rates or exempt Some capital gains taxed favorably or  exempt Austria, Brazil, China, Czech Republic, Finland, France, Greece, HK, Hungary, Ireland, Italy, Japan, Latvia, Malaysia,  Netherlands,  Nigeria, Philippines, Poland, Portugal, Singapore, South Africa, Sweden, Thailand, UK, US, Vietnam

2 – Heavy Dividend Tax

3 – Heavy Capital Gain Tax

4 – Heavy Interest Tax

5 – Light Capital Gain Tax

6 – Flat Flat and and Ligh Lightt

7 – Flat Flat and and Heav Heavy y

Progressive

Progressive

Progressive

Progressive

Flat

Flat

Some interest taxed at favorable rates or  exempt Taxed at ordinary rates

Some interest taxed at favorable rates or  exempt Some dividends taxed at favorable rates or exempt Taxed at ordinary rates

Taxed at ordinary rates

Taxed at ordinary rates

Some dividends taxed at favorable rates or exempt Some capital gains taxed favorably or  exempt Canada, Denmark, Germany, Luxembourg, Pakistan

Taxed at ordinary rates

Some interest taxed at favorable rates or  exempt Some dividends taxed at favorable rates or exempt Some capital gains taxed favorably or  exempt Kazakhstan, Russia, Saudi Arabia (Zakat)

Some interest taxed at favorable rates or  exempt Taxed at ordinary rates

Some capital gains taxed favorably or  exempt Argentina, Indonesia, Israel, Venezuela

Colombia

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Some capital gains taxed favorably or  exempt Australia, Belgium, India, Kenya, Mexico, New Zealand, Norway, Spain, Switzerland, Switzerland, Taiwan, Turkey

Taxed at ordinary rates Ukraine

Future value interest factor (if taxed annually): FVIFi = [1 + r(1 – t i)]n Tax drag may exceed the tax rate: compounds over time. Tax drag increases as the investment investment return increases. For deferred taxation: FVIFcg = (1+r)n – [(1+r)n – 1]tcg = (1+r)n(1-tcg) + tcg If cost basis differs: FVIF cgb = (1+r)n(1-tcg) + tcg – (1 – B)tcg = (1+r)n(1 – tcg) + tcgB; B is the percentage basis to market value Annual wealth-based taxes: FVIFw = [(1+r)(1 – tw)]n Annual return after realized taxes: r * = r(1 – piti – pdtd – pcgtcg); the p’s are the percentages of return and don’t need to add to 1 b/c unrealized capital gains are not included in the equation; does not capture tax effects of deferred CGs. Effective CGs tax rate: T* = tcg(1 – pi – pd – pcg)/ (1 – p iti – pdtd – pcgtcg) Future after-tax accumulation for each unit of currency in a taxable portfolio: FVIFtaxable = (1 + r *)n(1 – T*) + T* - (1 –  B) tcg n Accrual equivalent return: the IRR of the after-tax return: starting amount (1 + R AE AE) = after-tax return Accrual equivalent tax rate: the hypothetical tax rate that produces an after-tax return eq uivalent to the accrual equivalent return: r(1 – TAE) = R AE AE

Future after-tax accumulation of a contribution to a tax-deferred account (like IRA): FVIFTDA = (1 + r)n(1 – Tn) Future accumulation of a tax-exempt account (like Roth IRA): FVIFTaxEx = (1 + r) n Risk: if investment returns taxed annual at ti, then return is reduced to σ(1 – ti) Value created by using investment techniques that effectively manage tax liabilities: tax alpha asset location if strategy causes allocation of heavily taxed asset held in pension fund etc. to be too high, an offsetting o short position in heavily taxed asset outside the pension fund can offset the excessive exposure Trading behavior: optimally locating assets in TDAs and taxable accounts cannot overcome negative ne gative impact of poor investment strategy that either produces negative pretax alpha or is highly tax inefficient Tax loss harvesting: realizing loss to offset gain or income, thereby reducing current year’s tax obligation; recognizing an already incurred loss for tax purposes increases amount of net-of-tax money available for  investment o highest-in, first-out (HIFO) tax lot accounting: sell highest cost basis first Holding Period Management: discourage short-term trading; gross up available long-term gain if held by short-term tax rate to determine if short-term trade will yield greater; defer transaction just long enough for  long-term capital gains After-Tax Mean-Variance Optimization: pretax efficient frontiers may not be reasonable proxies for after-tax efficient frontiers; also substitute after-tax standard deviations of returns for pretax standard deviations in the optimization algorithm •

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Reading 16: Estate Planning in a Global Context Trust: vehicle through which an individual (settlor) entrusts certain assets to a trustee who manages the assets; many civil countries do not recognize foreign trusts 40963581.doc 12 of 114

Civil law: forced heirship rules: children have right to fixed share of parent’s estate (may exist regardless of estangement or  o nonmarital)  maybe move assets to offshore trust to avoid  maybe gift or donate assets during lifetime; some jurisdictions have “clawback” provisions for  lifetime gifts o spouses have guaranteed inheritance rights  community property regimes: each spouse has automatically passing, indivisible 1/2 interest in income earned during marriage (gifts and inheritances received b/f and after marriage are separate property) (other half through will or intestate)  separate property regimes: each spouse is able to own and control property as individual and to dispose, subject to spouses other rights •

 Net worth tax / Net wealth tax: on assets’ entire capital base lifetime gratuitous transfers (inter vivos transfers): lifetime gifts; gift tax may apply depending on residency or  domicile of donor, residency or domicile of recipient, tax status of recipient, type of asset and location of asset Testamentary gratuitous transfers: transfers upon death; taxation depending on residency or domicile of donor, residency or domicile of recipient, type of asset and location of asset taxes may apply to transferor or the recipient; may be flat or progressive; usually after deduction for statutory allowance; may depend on relationship of transferor or recipient (spouses often tax exempt) •

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Core Capital: amount of capital required to fund spending to maintain given lifestyle, fund goals and provide adequate reserves for unexpected commitments survival probability: multiply future cash flow needs by probability that such cash flow will be needed  p(H survives) x  p(W o  joint probability if married couple: p(survival) =  p(H survives) + p(W survives) –  p survives)  N   p ( Survival  ) × Spending    j   j PV(Spending need) = o   j (1 + r )   j =1 estimated that two people can maintain same living standard for 1.6 times the cost of one o discount such probable cash flow needs o  using the expected return of pension fund assets to discount liabilities they are intended to fund systematically under-prices those liabilities  Monte Carlo simulation w/ expected returns and volatility safety reserve: for capital market volatility and uncertain future family commitments; suggested 2 yrs o of spending Monte Carlo simulation: determine core capital that sustains spending at least, say, 95% of the simulated trials Ruin probability: probability of depleting one’s financial assets b/f death) o •

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volatility reduces future accumulations:  RG

≅

r  − 1

2

σ 

; geometric mean approximately equals

arithmetic mean minus half the volatility; also b/c withdrawals after down volatility reduce capital base Excess Capital: anything over core capital may gift during lifetime: certain gifts may be tax-free: allows for gifts to grow to benefit of don ee: relative after-tax value of  o tax-free gift made during one’s lifetime compared to b equest transferred as part of taxable estate is: •

 RV TaxFreeGif t  =

 FV Gift   FV  Bequest 

=

[1 + r  (1 − t  )]  g 

n

ig 

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o

taxable gifts: 

o

o

o o

 FV  Bequest 

[1 + r  (1 − t  ) ] (1 − T  ) n

=

 g 

ig 

 g 

[1 + r e (1 − t ie ) ] (1 − T e ) n

, if paid by recipient; efficient if gift tax is

lower than estate tax;  same if progressive tax rate (small gifts over time are efficient);   but U.S. and other jurisdictions may required cumulative lifetime gift and estate tax computation  generation skipping: transfer high-returning assets; relative value is 1/(1-T1), where T1 is tax rate of capital transferred from first to second generation; consider specific generation skipping transfer tax location of gift tax liability:  could result in taxation of donor and donee in case of cross-border gift 

o

 RV TaxableGif t  =

 FV Gift 

if paid by donor:  RV TaxableGif t  =

 FV Gift   FV  Bequest 

=

[1 + r  g  (1 − t ig  ) ]n (1 − T  g  + T  g T e ) [1 + r e (1 − t ie ) ] n (1 − T e )

; (benefit from

reduction of size of taxable estate) spousal exemptions: note that there are two, and good to use to transfer to someone else than to living spouse. Valuation discounts: tax levied on fmv, which wh ich requires valuation; lack of liquidity; lack of control; use family limited partnerships Deemed dispositions: gains may be taxed at death; d eath; may benefit from avoiding by gifting Charitable Gratuitous Transfers: 1. usually not subject to gift transfer tax; 2. may be ex empt from  paying tax on investment returns 

 RV CharitableGift  =

 FV CharitableGift   FV  Bequest 

=

(1 + r  g  ) n + T oi [1 + r e (1 − t ie ) ] n (1 − T e ) [1 + r e (1 − t ie ) ] n (1 − T e )

Estate Planning Tools: Trusts: relationship in which trustee holds and manages assets for benefit of beneficiaries; avoid probate revocable trust: settlor is responsible for tax payments and reporting; assets reachable by creditors o irrevocable trust: trustee responsible for tax payments and reporting; greater protection against o creditors fixed vs. discretionary trusts o control o asset protection (from creditors, from beneficiaries); use to avoid forced heirship rules o tax reduction: may be progressive schedule and move assets into lower bracket; time discretionary o distributions; create trust in low tax jurisdiction  however, income of trust may be taxable to settlor  Foundations: legal entity set up for particular purpose; can survive settlor  o o allow for settlor’s wishes to be carried out o control, avoidance of probate, asset protection, and tax minimization Life Insurance: death benefit proceeds paid to life insurance beneficiaries are tax exempt in may jurisdictions o  premiums also not in estate and not considered gift may have cash value building tax deferred o avoids probate o o  proceeds used to pay inheritance tax avoid forced heirship rules o •

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asset protection: premiums not available to creditors can combine w/ discretionary trust o Companies and CFCs: defer taxes; and set up in no-tax jurisdiction o however, tax rules may quash w/ deemed distributions o o

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Cross-Border Estate Planning: Hague Convention of the Conflict of Laws Relating to the Form of Testamentary Dispositions: will valid if  consistent w/ internal law associated w/: o  place will made nationality, domicile, or habitual residence of testator  o o location of immovable assets covered under will o certain exceptions, though, maybe requiring two wills o required recognition of written trusts if:  assets constitute separate fund and are not part of trustee’s own estate  title to trust assets stands in name of trustee or name o f another on behalf of trustee  trustee has power and duty to manage, employ or dispose of assets in accordance w/ trust and special legal duties Tax system: taxation of income: source jurisdiction / territorial tax system vs. residence jurisdiction; (U.S. is o worldwide!) taxation of wealth and wealth transfers: may be source or residence based o exit taxation: deemed disposition on unrecognized gains; taxation on income during “shadow period” o Double Taxation: o residence-residence conflict: two counties both claim residence o source-source conflict: two claim source (say based on location of assets and management of assets) o residence-source conflict: most common and most difficult to avoid;  source country commonly viewed to have primary jurisdiction; residence country typically expected to provide relief   Foreign tax credit provisions: credit method: reduces tax liability for foreign taxes paid: TCreditMethod = Max[TResidence, TSource] Exemption Method: no domestic tax on foreign-source income: TExemptionMethod = TSource usually the few territorial-based systems adopt o Deduction Method: partial concession: TDeductionMethod = TResidence + TSource(1-TResidence) = TResidence + TSource – TResidenceTSource Double Taxation Treaties: o  OECD model treaty sanctions the exemption and credit method to resolve residence-source conflicts interest and dividends: source taxation by withholding by source country; rates encouraged to be limited to 15% 1 5% and 10% respectively. capital gains are taxed in residence country, except on immovable property also resolves residence-residence conflicts based on following ordered list: 1.  permanent home; 2. center of vital interests; 3. habitual dwelling; 4. citizenship (don’t typically resolve source-source conflicts) o Transparency and Offshore Banking:  consider tax avoidance vs. tax evasion •

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 banking secrecy: benefits are security, privacy, intra-family dynamics and politics, and efficient for clients residing abroad tax evasion strategies predicated on bank secrecy and being exposed by increasing info exchange b/w tax authorities Qualified Intermediaries: banks that document info for all customers and provide info about U.S. customers upon request, w/o requirement to provide info on other non-U.S. no n-U.S.  persons beneficially owning U.S. securities •

Reading 17: Low-Basis Stock  Usually resulting from:  being an entrepreneur   being an executive  being an investor  • • •

Issues: • • •

Psychological risk and return taxes

Specific risk / residual risk increases from investor, to executive, to entrepreneur  Equity Holding Lives: 3 stages: 1. entrepreneurial stage: high specific risk: no diversification desired at this stage; seeking max profit 2. executive stage: after taken business public; relatively concentrated positions w/ some entrepreneurial bent still; greater diversification as one descends the management hierarchy 3. investor stage: multisecurity portfolio (either diversified investor stages or   indexing stage (indexing being more diversified)): no longer have control over underlying fortunes of  company Reducing exposure: outright sale: simplest and most expensive; results in max flexibility; eliminates residual risk; lower  amount of money to reinvest exchange funds: pool concentrated positions from multiple individuals i. public exchange exchange funds: funds: partnership partnership for for >= 7 yrs; 20% exposure exposure to other other illiquid illiquid investment investments; s;  portion of pool distributed after 7 yrs  but, management costs, lack of control and inflexibility ii. private private exchange fund alternat alternative: ive: usually usually single single security; security; partner partner w/ another another investor investor who  purchases same stock at current market prices; p’ship then enters into series of partial hedging,  borrowing and reinvesting transactions (avoiding constructive sales); increases borrowing ability lessens psychological blow no need for exposure to illiquid investments 7 yrs  but unclear whether tax sound completion portfolios: •

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i. single single asset class completi completion on portfolios: portfolios: make other other investments investments to offset offset the concentrated concentrated  position; may reinvest dividends  passive structured strategy: reinvest dividends and use all available opportunities to harvest investable losses experienced by one or several of the stocks in the completion  portfolio. ii. multi-asset multi-asset class class completion completion portfoli portfolios: os: reach across across asset asset or sub-asset sub-asset classes classes requires substantial pool of other assets diversification process takes time hedging strategies: diversified but to avoid constructive sales; borrows against value of portfolio (monetization) and reinvests i. Cons Constr truc ucti tive ve sale sale:: short sale of same or substantially identical proprty offsetting notional principal K wrt the same or substantially identical property or  futures or forward K to deliver same or substantially identical property ii. Equity Equity collars: collars: pure hedging hedging strategy: strategy: buy put put and sell call (can (can cost money, money, be cashless, cashless, or  income-producing). suggested that 15% remaining exposure avoids constructive sale iii. Monetization Monetization of positio position: n: w/ equity equity collar, collar, could borrow borrow up to ~90% of put strike strike price; however, if more than 50%, must be nonpurpose loan and be intended for investments in anything other than equities (however, may still increase leverage through margin). iv. Variable Variable Pre-Paid Pre-Paid Forwards: Forwards: forward forward sale sale of contingent contingent number of shares shares of underlyi underlying ng stock  w/ agreed future delivery date in exchange for cash advance today. “properly constructed and documented, does not constitute a constructive sale and not subject to margin lending restrictions.” (unbalanced collar) v. debate over over whether whether interest interest must be capitalized capitalized for for tax purpose purposess •

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Reading 18: Goals-Based Investing: Integrating Traditional and Behavioral Finance Define portfolio efficiency in terms of client goals instead of relying on traditional measures of return and standard deviation, then create strategies matched to each goal Investor goals: 1. lifestyle needs, 2. wealth transfers, 3. charitable gifts Risk Measurement: traditionally standard deviation, etc. i. however, however, return distribut distributions ions are non-normal: non-normal: skewed, skewed, excess kurtosis kurtosis and heteroske heteroskedasti dasticc ii. doesn’t doesn’t describe describe risk in terms terms of clear outcomes outcomes / the way investo investors rs experience experience risk  risk  loss aversion: investors are not risk averse, but loss averse i. risk measures measures should should address address : likelihood likelihood that that loss will will occur, severity severity of loss loss or both (say (say  probability of loss and downside deviation) risk measures are usually annualized or some short period, failing to convey risk over multiple periods i. conside considerr trough troughss occurr occurring ing at at end date date •

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Risk Profiling: Decision Framing: slight differences in the way that questions are posed lead to very different answers about  people’s preferences Mental Accounting: multiple attitudes about risk; manage risk on goal-by-goal basis; maintaining separate investment accounts, either mentally or in practice, a nd making decisions differently depending on the nature of  the account. •

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Managing Behavioral Biases: loss aversion: develop strategies to manage losses mental accounting: develop strategies that can be aligned w/ investors’ separate goals and accounts  biases should be controlled rather than accommodated Overconfidence: overestimate abilities; take risks w/o commensurate returns; overtrade o Hindsight bias: believe that predicted event when didn’t o Overreaction: to overinterpret patterns that are coincidental and unlikely to persist o Belief perseverance: unlikely to change opinions even when new info becomes available o Regret avoidance: tendency to avoid actions that could create discomfort over prior decisions, even o though those actions may be in the individual’s best interest  hold losers too long (disposition effect) recommendations: o  goals and preferences should be defined as clearly as possible and supported through risk  management, using measures such as probability probab ility of breaching goal and potential loss   progress towards goals should be monitored, w/ performance e valuated in this context  strategy adjustments should be based on changes in circumstances or goals rather than behavioral factors • • •

Implementing a Goals-Based Approach: goals-based investing: aligning investment strategies w/ goals of individual investor  match investment strategies to four buckets: liquidity, income, capital preservation and growth o investing to meet current lifestyle needs: measuring risk to current lifestyle goals: o  use efficient frontier but have worst sustainable spending rate as risk axis and expected spending rate as return axis p robability that sustainable spending rate will fall as  event specific rather than period specific: 1% probability far as or below the worst level o implementing the new measures of reward and risk  lifestyle protection strategies: investor determines minimum sustainable spending rate based on lifestyle o needs, which is translated to target for potential p otential loss, and portfolios are considered; expected spending rate can be increased if investor is willing w illing to accept a lower sustainable spending rate in a worst-case scenario cash flow matching: state current lifestyle goals more precisely using targets for amount of cash required o in each period; can use laddered bond portfolios to match expenses; high degree of certainty that CF targets are met  not appropriate if expense patterns likely to change  low return  CFs are predictable but corpus may be volatile Investing for a fixed planning horizon: for growth rather than expenses (say retirement, or college enrollment) measure reward as expected portfolio value at horizon date o o risk measured depending on psychology of investor   amt of capital that could be lost  measure of worst portfolio value at horizon based on confidence interval  (efficient frontier w/ axes: worst portfolio value and expected portfolio value)  for fixed horizon strategy, risk free investment would be high-quality zero-coupon bond w/ maturity near horizon date; then balance w/ other investments  but if horizon likely to change, or is zero-coupon bond sufficient return, or volatility of  corpus ok? •

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Reading 19: Lifetime Financial Advice: Human Hu man Capital, Asset Allocation, and Insurance Human Capital: economic PV of investor’s future labor income early life stages: financial and investment capital should hedge and diversify human capital implications of model: younger investors invest more in stocks than older investors o investors w/ safe labor income invest more in financial portfolio in stocks o investors w/ labor income that is highly correlated w/ stock markets invest their financial assets in less o risky assets ability to adjust labor supply increases as investor’s allocation to stocks o labor income typically has low correlation w/ stock market n  E [ ht  ]  HC ( x ) = t − x t = x +1 (1 + r  + v ) Human capital as a risk-free asset: invest in stocks and gradually scale back as gets older  Human capital as a risky asset: 1. if correlated w/ other risky financial assets, buy risk-free asset when young and gradually move to risky-assets (as risky human capital declines); 2. if not correlated w/ other risky financial assets, same as case 1. Impact of initial financial wealth: greater percentage allocation to risk-free asset (b/c initial wealth reduces  portion of wealth that is safe human capital) cap ital) Correlation b/w wage growth rate and stock returns: make greater allocation to risk-free asset • •

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Implications for Advisors: 1. investors should invest financial assets to diversify and balance human capital 2. young you ng inve investo storr w/ safe safe human human capita capitall shoul should d inves investt more more fina financi ncial al asse assets ts in risk risky y asset assetss than than olde older  r  3. if hum human an cap capit ital al cor corre rela late ted d to ris risky ky ass asset ets, s, red reduc ucee allo alloca cati tion on to to risk risky y asse assets ts Mortality risk: • • •

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asset allocation and life insurance decisions should be made jointly life insurance is perfect hedge of human hu man capital in event of death optimal amt of insurance depends on: 1. expected value of human capital and 2. risk-return characteristics of the insurance contract. life insurance (θ) optimization: m ax E [ (1 −  D ) ( 1 − q x )U alive ( W  x +1 +  H  x +1 ) +  D( q x ) U dead ( W  x +1 + θ  x ) ] θ  x ,α  x

i. q is subj subject ective ive prob probabi abilit lity y of deat death h ii. ii. U is is uti utili lity ty func functi tion on as correlation b/w shocks to income and risky assets increases, optimal allocation to risky assets declines and optimal quantity of life insurance declines (implies lower amt of human capital) the more financial assets one has, the less optimal quantity life insurance less risk tolerance, the more risk-free assets and the more life insurance demand for insurance decreases w/ age (primary driver of life insurance is human capital)

Retirement Portfolio and Longevity Risk: goals: 1. comfortable life style and 2. bequests risks: 1.financial market risk; 2. longevity risk; and 3. risk of not saving enough (including effects of  inflation) i. financial financial market market risk: portfol portfolio io values fluctuat fluctuatee in short run, and may may occur early early in retirement retirement mitigate w/ diversification ii. longevi longevity ty risk risk:: outl outlive ive assets assets hedge w/ insurance products: lifetime annuities / payout annuities • •

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1. fixed: fixed: doesn’t doesn’t account account for erosion erosion by inflati inflation; on; typically typically can’t can’t trade trade out of once once  purchased 2. or variable: variable: fluctuates fluctuates w/ w/ performan performance ce of funds funds investor investor chooses chooses main sources of income: social security; DB pension plans; personal savings iii. risk of spending spending uncerta uncertainty inty:: may not save save enough to to adequately adequately fund retir retirement ement  behavioral issue combination of types of annuitization and systematic withdrawals helps manage financial risks and income needs Reading 20: Managing Institutional Investor Portfolios •

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DC plans may be profit-sharing: based on plan sponsor’s profits sponsor directed: sponsor chooses the investments  participant directed: sponsor provides menu and participants determine DB plans: funded status: fully funded; has pension surplus; underfunded ABO: PV of benefits if plan terminated immediately (for accumulated service but not future service and wage increases) PBO: PV of benefits if plan assuming future comp increases (funding status usually determined off of  PBO) Total future liability: PV of accumulated and projected future service benefits including projected future comp increases (most comprehensive but most uncertain; used internally) retired lives (retired workers) vs. active lives (active workers) • •

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DB Investment Policy Statement: Risk objectives: •

Factors Affecting Risk Tolerance and Risk Objectives of DB Plans Category Variable Explanation Plan Status Plan funded status (surplus or   Higher pension surplus or higher funded status deficit) implied greater risk tolerance Sponsor financial status Debt to total assets; Current and Lower debt ratios and higher current and expected and profitability expected profitability  profitability imply greater risk tolerance Sponsor and pension fund Correlation of sponsor operating The lower the correlation, the greater risk tolerance, common risk exposures results w/ pension asset returns all else equal Plan features Provision for early retirement; Such options tend to reduce the duration of plan Provision for lump-sum liabilities, implying lower risk tolerance, all else distributions equal Workfo Workforce rce charact characteri eristi stics cs Age of workfo workforce rce;; Acti Active ve lives lives The younger the workforce and the greater the relative to retired lives  proportion of active lives, the greater the duration of   plan liabilities and the greater the risk tolerance

i. Asset/liab Asset/liabilit ility y management management (ALM): subset subset of company’s company’s overall overall risk management management practice practice that typically focuses on financial risks created by the interaction of assets and liabilities; for given financial liabilities, asset/liability management involves managing the investment of assets to control relative asset/liability values. ii. DB plans may state state risk risk objective objective relative relative to level of pension pension surplus surplus volatility volatility iii. Shortfall Shortfall risk: risk: risk (probabili (probability) ty) that portfoli portfolio o value will fall below below some minimum minimum acceptable acceptable level over some time horizon iv. risk objective objective to: minimiz minimizee year-to-year year-to-year volatili volatility ty of future contribut contribution ion payments payments 40963581.doc 20 of 114

v. risk objective objective to: minimiz minimizee probability probability of making future future contributio contributions, ns, if sponsor is currentl currently y not making any contributions b/c plan is overfunded Return objectives: broadly: to achieve returns that adequately fund pension liabilities on inflationadjusted basis i. consider: consider: current current funded funded status; status; contributio contributions ns in relation relation to accrual accrual of pension pension benefits; benefits; ii. return return objective objective may be such such to eliminat eliminatee future pension pension contri contribution butionss iii. return return objective objective may be such such to increase increase pension pension income income in income income statement statement iv. may have separat separatee return return objectives objectives for each each of retired retired lives lives and active active lives lives Liquidity requirement: net cash outflow: benefit payments minus contributions i. consider consider percentage percentage of retired retired lives; lives; corporate corporate contributi contributions ons in relation relation to benefit benefit disbursements; options for early retirement or option to take lump-sum payments Time horizon: i. whether whether plan plan is going concern concern or terminati termination on expected expected ii. age of workf workforc orcee and propor proportio tion n of active active lives lives iii. iii. may may be mult multis ista tage ge Tax concerns: usually tax exempt (though contributions and termination involve tax planning) Legal and regulatory factors: i. ERISA for for corporat corporatee and multi-em multi-employe ployerr plans: plans: standards standards of of care ii. Taft-H Taft-Hart artley ley Labor Labor Act Act for for union union plans plans iii. fiduciary: fiduciary: person person standing standing in special relation relation of trust trust and responsibilit responsibility y wrt other parties parties assets to be managed solely in interests of beneficiaries Unique circumstances: i. due dilige diligence nce wrt alte alternat rnative ive invest investmen ments ts ii. prohibitio prohibitions ns on investment investment in certain industries industries w/ negative negative ethical ethical or welfare welfare connotations; connotations; or  in companies operating in certain countries Corporate Risk Management and the Investment of DB Pension Assets: managing pension investments in relation to operating investments: if business and pension risks are  positively correlated, high degree of operating risk would limit amt o f risk that pension could assume coordinating pension investments w/ pension liabilities: ALM perspective to match interest-rate sensitivity of assets and liabilities •

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sponsor directed: IPS is simpler subset of DB plan IPS  participant-directed: i. diversific diversification: ation: Section Section 404(c) of ERISA ERISA safe safe harbor for DC DC plan sponsors sponsors against against claims claims of  insufficient or imprudent investment choice if plan has 1. at least 3 investment choices diversified versus each other and 2. provision for participant to move freely among options. ii. Company stock: stock: should should be limited limited to allow for for diversif diversificati ication on  plan participants set on risk and return objectives ob jectives IPS becomes overall set of governing principles rather than IPS for a specific plan participant

Hybrid and other plans: combination of DB (benefit guarantees, years of service rewards, ability to link retirement  pay to % of salary) and DC (portability, administrative ease and un derstandability) plans cash balance plans, pension equity plans, target benefit plans and floor plans Cash Balance Plan: DB plan w/ benefits displayed in individual recordkeeping accounts; facilitates  portability to a new plan. i. contrib contributi ution on credit credit:: % of pay pay based based on on age ii. earnings earnings credit: credit: % increase increase in acct balance balance typically typically tied to long-te long-term rm interest interest rates iii. no actual actual account account balance balance b/c b/c no no separat separatee account account iv. some some allow allow for for some some invest investmen mentt choices choices • •

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ESOP: DC plans that invest all or a majority of assets in company stock; contributions based on employee pay; vesting schedules; (not diversified)

Foundations and Endowments: Foundation: grant-making institutions funded by gifts and investment assets i. typi typical cally ly hav havee singl singlee donor  donor  ii. have mini minimum mum leve levels ls of annual annual spendi spending ng iii. iii. typica typically lly do not not receive receive new contr contribu ibuti tions ons iv. typically typically four four types: types: 1. independent, independent, 2. company company sponsored, sponsored, 3. operating operating and 4. community community •

Type of Foundations in U.S. Foundation Description Type Independent Independent grant-making foundation organization established to (private or  aid social, educational, family) charitable, or religious activities CompanyA legally independent grantsponsored making org w/ close ties to foundation corp providing funds

Operating foundation

Org that uses its resources to conduct research or provide a direct service (e.g., operate a museum)

Community foundation

A publicly supported org that makes grants for social, educational, charitable, or  religious purposes. A type of public charity.

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Source of   Funds Generally an individual, family, or group of individuals

Decision-Making Authority Donor, members of donor’s family, or independent trustees

Annual Spending Requirement At least 5% of 12-month average asset value, plus expenses associated w/ generating investment return

Endowment and/or annual contributions from a profitmaking corp Largely the same as independent foundation

Board of trustees, usually controlled  by sponsoring corp’s executives

Same as independent foundation

Multiple donors; the  public

Independent  board of directors

Must use 85% of interest and dividend income for active conduct of institution’s own  programs. Some are also subject to annual spending requirement equal to 3.33% of assets. Board Board of direct directors ors No spendi spending ng requi requirem rement ent..

Foundation IPS: i. risk objective objectives: s: desire desire to keep spending spending whole in real terms terms or to grow grow instituti institutions, ons, but can be more fluid or creative and aggressive than pensions; still ability and willingness ii. return return objectives: objectives: total return; return; long-term long-term return return objective objective for foundations foundations w/ indefini indefinitely tely long horizons: preserve real (inflation-adjusted) value of investment assets while allowing spending at appropriate (statutory or decided-upon) decided-u pon) rate; intergenerational equity/neutrality: equitable  balance b/w interests of current and future beneficiaries of foundation’s support; spending (say 5%) times investment management expenses (say 0.3%) times inflation (say 2%) iii. liquidity liquidity requireme requirements: nts: anticipate anticipated d (spending (spending rate) or unanticipate unanticipated d needs for cash in excess of  contributions; investment management expenses don’t count toward payout req, though overhead associated w/ grant making does. may use smoothing rule that averages asset values ov er period of time to dampen spending rate’s response to asset value fluctuations IRS allowes certain carry-forwards and carry-backs w/i limits •

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cash reserve to allow for end-of year rush spending in case of large asset growth iv. Time horizon: horizon: usuall usually y into perpetui perpetuity, ty, but someti sometimes mes intended intended to be “spent “spent down” down” v. Tax Tax conc concer erns ns:: avoid UBTI, including debt-financed portion of income from debt-financed real estate  private foundations must estimate and pay quarterly in advance 2% tax on net investment income: dividends, interest and cap gains less foundation’s expenses related directly to production of such income; reduced to 1% if charitable distributions for year  >= 5% and avg of previous 5 yrs’ payouts plus 1% of net investment income. vi. Legal Legal and regula regulator tory y fact factors ors:: IRC Section 4944: graduated excise ex cise taxes if jeopardize carrying out of tax-exempt  purposes Uniform Management of Institutional Funds Act (UMIFA): primary state legislation governing any entity organized and operated exclusively for educational, religious, or  charitable purposes. vii. vii. Uniqu Uniquee circu circums msta tanc nces es:: restrictions on diversification (may avoid w/ swaps) Endowments: long-term funds generally owned by operating non-profit no n-profit institutions institutions involved in charitable activities i. not subje subject ct to legall legally y require required d spending spending level level ii. may be supplemen supplemented ted w/ quasi-end quasi-endowment owments: s: funds funds functionin functioning g as endowment endowment (FFE) w/ no spending restrictions iii. usually usually several funds, funds, each w/ specific specific indenture indenture detailing detailing conditions conditions and intended intended uses of gifts,  but may be unrestricted iv. UMIFA both both income income and cap gains (real (realized ized and unreali unrealized) zed) included included in determin determining ing total total return, freeing from strictures of yield as spending limit v. frequently frequently use trailin trailing g market value in calcu calculatin lating g spending, to create create stability; stability; possible possible rules: rules: simple spending rule: Spendingt = Spending rate x Ending market valuet-1 Rolling three-year avg spending rule: Spendingt = Spending rate x (1/3) [Ending market valuet-1 + Ending market valuet-2 + Ending market valuet-3] Geometric smoothing: Spendingt = Smoothing rate x [Spending ratet-1 x (1 + Inflationt1)] + (1 – Smoothing rate) x (Spending rate x Beginning market valuet-1); smoothing rate usually 60 to 80% vi. vi. En Endo dowm wmen entt IPS: IPS: Risk objectives: consider in conjunction w/ spending policy and long-term objective 1. w/o smoothi smoothing ng rule, rule, may have less less toleran tolerance ce for volatility volatility 2. consider consider endowment’s endowment’s role role in operati operating ng budget and abilit ability y to adapt to drops drops in spending i. correlatio correlation n w/ donor base base may limit limit ability ability to take take risk b/c b/c cannot rely rely on donors in down markets 3. consider consider recent recent returns returns in relation relation to smoothi smoothing ng rule (high (high recent return returnss indicates greater risk tolerance) 4. may have shortshort-term term perform performance ance time time horizons horizons limited limited risk toleran tolerance ce Return objectives: have high return objectives: significant, stable and sustainable flow of income to operations 1. should maintain maintain long-ter long-term m purchasing purchasing power after inflation inflation 2. consider consider high inflation inflation for for U.S. higher ed ed (HEPI averages averages 1% more more than than CPI or  GDP deflator) 3. low-volati low-volatility lity,, low-return low-return portfoli portfolio o increases increases risk of endowment endowment failing failing objectives •

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4. returns returns must exceed exceed spending spending rate, rate, expected expected inflation inflation rate rate and cost of of generating generating investment returns 5. use Monte Monte Carlo Carlo simulati simulation on to set (may be higher than point point above) above) Liquidity requirements: perpetual and measured spending limit need for liquidity 1. need cash cash for for capital capital commitments commitments and for for rebalan rebalancing cing 2. mayb maybee major major capi capita tall proje project ctss 3. genera generally lly suit suited ed for illiq illiquid uid invest investmen ments ts Time Horizon: extremely long 1. planned planned decapitalizat decapitalizations ions (large (large projects) projects) may may make for for multista multistage ge horizons horizons Tax concerns: exempt from taxation 1. avoid UB UBTI 2. dividend dividend withhol withholding ding tax from non-U.S. non-U.S. securi securities ties Legal and regulatory factors: 1. UMIFA: i. allows allows for delegatio delegation n of investment investment respons responsibil ibility ity to external external advisor advisorss and managers and setting comp for such ii. board must must “exerci “exercise se ordinary ordinary busine business ss care care and prudence” prudence” iii. iii. spendi spending ng gain gain as as well well as as incom incomee ok  iv. if fall fall below below historical historical book, then spend only income income 2. 501(c)(3): 501(c)(3): ensure ensure that that no part of net net earnings earnings inure inure or accrue accrue to benefit benefit of any  private individual i. excise taxes taxes for indivi individuals duals receivi receiving ng “excess “excess benefit benefit transacti transactions” ons” (too (too high comp) Unique circumstances: 1. variance variance in size: variety variety of expertise expertise and resourc resources es 2. diligence diligence of of alternat alternative ive investm investments: ents: active active management management 3. whether whether investments investments limit limited ed to Qualified Qualified Purchaser Purchaserss (>$25M) (>$25M) can be consider considered ed 4. ethica ethicall invest investmen mentt polici policies: es: i. voting voting shareholder shareholder proxies proxies on issues issues of social social or political political signifi significance cance ii. exclusions exclusions for for companies: companies: child labor, labor, gamblin gambling, g, tobacco, tobacco, firearms firearms,, violations of human rights

Insurance: 1. life; 2. health; 3. property and liability life insurance cos: i. risk object objectives: ives: to to fund future future policy policyholder holder benefi benefits ts and claims; claims; looked upon as quasi-trust fund—so conservative fiduciary principles; sensitive to change of principal loss or interruption of income; must maintain asset valuation reserve based on NAIC quality tests; GAAP-required market valuations increase balance sheet volatility; also fund interest-rate-sensitive liabilities: annuities and deposit-type contracts Valuation concerns : a/l duration mismatches create risk of capital adequacy a dequacy problems during periods of changing interest rates: limits risk tolerance Reinvestment risk: ability to invest maturing assets at rates sufficient to cover the guarantee rate of annuity contracts on which no interest is paid until maturity Credit risk : risk objectives object ives may relate relat e to losses caused caus ed by credit risk  Cash flow volatility : low tolerance for loss of income or delays in collecting and reinvesting cash flow from investments competition has motivated greater risk tolerance ii. ii. Retu Return rn objec objecti tive ves: s: •

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 policyholder reserve (BS liability of estimated pmts to policyholders) rates set by actuaries; to obtain a net interest spread to increase surplus policyholder reserves total return is difficult as only asset side of BS would reflect resulting volatility competitive pressures to offer competitive crediting rates Segmentation: sub-portfolio return objectives; need to grow surplus to support expanding expand ing business volume iii. iii. Liquid Liquidity ity requir requireme ements nts:: disintermediation: withdrawing or borrowing against cash value; or surrendering policy for cash value; has resulted in actuaries reducing duration estimates and portfolio managers to reduce duration of portfolio Asset marketability risk: liquidity needs limit ability to invest in private placement  bonds, commercial mortgage loans, equity real estate an d venture capital; also liquidity requirements for forward commitments to purchase private placement bonds or  mortgages derivatives and lines of credit have decreased liquidity requirements iv. Time horizon: horizon: traditional traditionally ly the classic classic long-term long-term investor, investor, but segmentation segmentation creates creates unique time horizons; ALM has tended to shorten time horizon v. Tax concerns: concerns: subject subject to income, income, capital capital gains, etc.; etc.; focus on after-ta after-tax x returns; returns; only corporate corporate share of income (not policyholder share) is taxable could be tax law changes chan ges regarding deferral from inside buildup of cash values v alues vi. Legal and regulatory regulatory factors: factors: heavily heavily regulated regulated by states—p states—permit ermitted ted lines of business, business, product product and policy forms, authorized investments; industry accounting rules and financial statement forms Eligible investments: asset classes and quality standards; interest coverage ratios or  minimum credit ratings; max allocation to common stocks (~20% in U.S.) Prudent Investor Rule : replaced laundry lists of approved investments Valuation methods: uniform valuation methods established and administered by NAIC vii. Unique circum circumstanc stances: es: say company’s company’s size size and surplus surplus position position non-life insurance cos: (including health, property, liability, marine, surety and worker’s comp): differences from life: shorter durations; longer claim processing and payments periods some liabilities exposed to inflation risk (but not interest rate risk directly) liabilities are relatively uncertain in value and timing; greater operating volatility ii. underwritin underwriting g (profitabili (profitability) ty) cycle: cycle: 3 to 5 yrs; result resulting ing from adverse adverse claims experienc experiencee or   periods of extremely competitive pricing (often coincide w/ business cycle an d require liquidation of investments) iii. models attempt attempt to account account for: for: 1. underwritin underwriting g cycle; 2. liabilit liability y durations durations by product product line; 3. any unique cash outflow characteristics non-life insurance co IPS: i. Risk objectives objectives:: quasi-fiducia quasi-fiduciary ry role; risk risk of catastrophic catastrophic events; events; current cost cost or replacement replacement cost coverage: inflation risk; Cash flow characteristics: can be erratic; low tolerance for loss of principal or  diminishing investment income; (no regulatory required asset-valuation reserve); ratio of casualty insurance co’s premiums to total surplus: generally 2-to-1 or 3-to-1 Common stock holdings to surplus ratio: often self-imposed limits on common stock  holdings ii. ii. Retu Return rn objec objecti tive ves: s: Competitive policy pricing: lead to high return objectives; insurance cos may lower   premiums as a result of past high returns •

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Profitability: investment income and portfolio return are primary profitability determinants; influenced by underwriting cycle; maximize return on capital and surplus to extent that prudent ALM, surplus adequacy considerations and management  preferences allow (rather than policy crediting rate); investment returns expected to offset underwriting losses 1. profitabi profitability lity measured measured using using “combined “combined ratio”: ratio”: % of premi premiums ums that insura insurance nce co spends on claims and expenses (been over 100%) Growth of surplus: allows for expansion of volume of underwriting Tax considerations: balance of taxable and tax-exempt bonds; managing and optimizing operating loss carrybacks and carryforwards Total return management: active bond portfolio management strategies have increased as a result of accounting rules requiring capital gains and losses to flow through income statement Liquidity Liquidity requiremen requirements: ts: typically typically maintains maintains portfolio portfolio of short-term short-term securitie securitiess and maintains  balanced or laddered maturity schedule uncertainty of cash flow variable tax position results in liquidity requirements to alter amount of tax-exempt holdings interest rate conditions Time Time hor horiz izon on:: casualty liabilities typically shorter duration than that of life insurance underwriting cycles yield curve for tax-exempts is steeper, so move out on yield curve for yield 1. may be be willing willing to sacrif sacrifice ice A/L A/L matches matches to degree degree historically long-term for common stock, but recently more turnover in common stock   b/c realized gains and losses flow through income statement Tax Tax conc concer erns ns:: current tax provisions require series of calculations to determine net tax levied on taxexempt bond income; hence careful mix of tax-exempt and taxable securities uncertainty of further tax code modification Legal Legal and regula regulator tory y fact factors ors:: less regulated than life insurance; classes of eligible assets and quality standards otherwise remainder can be invested in broad b road array of assets (though some states have additional reqs on max asset class holdings) not required to maintain asset valuation reserve new U.S. risk-based capital regulations: min amt of capital that must hold as function of  size and degree of asset risk, credit risk, underwriting unde rwriting risk, and off-balance sheet risk  Determ Determina inatio tion n of portfol portfolio io polici policies: es: limited risk tolerance is dominant capital appreciation to build surplus base and support additional investment in business underwriting experience current tax policy •

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net interest margin: net interest income divided by avg earning assets interest spread: avg yield on earning assets minus avg % cost of interest-bearing liabilities leverage-adjusted duration gap: DA – kDL where DA is duration of assets, DL is duration of liabilities and k = market value of liabilities over market value of assets; positive interest rate shock: market value of net worth will decrease for bank w/ positive gap; unaffected w/ zero gap, and increase w/ negative gap.  position and aggregate Value at Risk (VAR): minimum value of losses expected over specified time at give  probability credit measures: internally developed and other like CreditMetrics: overall portfolio objectives: manage overall interest rate risk of balance sheet o manage liquidity o o  produce income manage credit risk  o  pledging requirement: pledge gov’t securities against uninsured portion of deposits (in U.S.) Bank IPS: risk objectives: ALM considerations focusing on funding liabilities; below-average risk tolerance o o return objectives: earn a positive spread over cost of funds o liquidity requirements: net outflow of deposits; demand for loans; management and regulatory concern o time horizon: overall short maturity for liabilities than for portfolio; generally 3 to 7 yrs (intermediate) o Tax concerns: securities portfolios are fully taxable; no longer tax e xemptions for municipal securities etc.; securities gains and losses affect net operating income: leads to managing earnings Legal and regulatory factors: reg restrictions on holding common shares and below-investment-grade o risk fixed-income securities  hold short-term gov’t securities: legal reserve and pledging reqs  risk-based capital regs Basel II: minimum 8% capital requirement for assets weighted 0%, 20%, 50%, 100% and 150% Unique circumstances: no common unique circumstances o •

other institutional investors: mutual funds; closed-end funds; unit trust; ETFs; commodity pools; hedge funds; nonfinancial corporations (major investors in money markets) Reading 21: Linking Pension Liabilities to Assets Selecting portfolios from asset-only perspective implicitly assumes that liabilities have no market risk   pension liabilities: PV of deferred wages; focus on volatility of estimated benefit pmts and how they change over time  Bt  V  L = o t  t  ( 1 + r t  ) •

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active participants: benefits attributable to past service and wages (accrued benefits) and attributable to future service and wages (future benefit) accrued benefits: fixed unless inflation indexed future benefits: risk is capital market driven for funded liabilities; if plan is frozen, then zero future benefit future wages: estimated future wage increases/benefits: future wage liability; o  both real wage growth and wage inflation  future wage inflation: long-term relationship b/w general inflation and wage inflation; exposed only until retirement, after which fixed so combination of real rate bonds and nominal bonds  future real wage growth: economic growth through labor’s share of   productivity increases; evidence of stability of share of labor in national income, so linked to productivity increases; fixed at retirement, though so combination of equities and nominal bonds  future services rendered: uncertain future participants: rarely funded; (zero if closed to new entrants) • •

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Market Related Exposures and Liability Mimicking Assets Portion ion of of th the In Investm estmeent Bench nchmark Mark arket Re Relate ated Ex Exposur sures Inactive Term structure Active-accrued Term structure Active-future wage Inflation Growth term structure o

Liab iabili ility Mimickin king Ass Asseets Nominal bonds Nominal bonds Real rate bonds Equities  Nominal bonds

 Non-Market Related Exposures: Liability Noise:   plan demographic experience different from actuary’s model given certain underlying  probabilities  model uncertainty: uncertain probabilities  inactive participants: mortality experience differing from model: difficult to hedge; also uncertainty of age of retirement  active participants: mortality assumption; withdrawal, disability, retirement

Linking assets and liabilities via fundamental factors: combination of nominal bonds, real rate bonds and equities accrued benefit: discount rate market-related exposure -->term structure-->real rate, inflation and nominal  bond premium future wage liability-->change in wage level-->economic growth and inflation •

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(1 + r t  ) t   B ( (1 +  g )  s − 1)((1 + r ) d − s − 1) = • ; s yrs to retirement r  −  g  (1 + r ) d  t 

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resulting sensitivity exposures sets asset allocation and is liability mimicking portfolio; is also appropriate investment benchmark; this low risk portfolio is the baseline: often greater allocation to equities while minimizing amt of unrewarded risk taken versus liability hedge the liability w/ derivatives o use remaining capital on efficient return generation (asset-only) o 40963581.doc 28 of 114

Reading 22: Allocating Shareholder Capital to Pension Plans Marked-to-market funding status is picture of current status and doesn’t reveal risk of status change: asset/liability mismatch is great concern; equity portion of pension portfolios often even larger than entire market cap of company mismatch doesn’t show up in accounting statements equivalent to fixed-interest for equity swap  pension assets are encumbered by a lien against by the pensioners, while gains and losses flow to shareholders PBGC bears losses from default study result: companies w/ larger fraction of equity in pension portfolio tended to have larger beta • • • • • •

By failing to take account of pension assets and liabilities when estimate WACC, companies probably distorting operating risk: 1. leaving out pension risk from total risk; 2. understates leverage ratio result is larger WACCs: too high of hurdle rates  by lowering risk in pension plan, risk is freed up to be spent in core operations risk budget: o  determine unleveraged/asset beta by adding pension assets to total assets and pension liabilities to total liabilities; the beta of the assets will be the beta of the stocks in portfolio times % of   portfolio plus the beta of bonds (0). Then calculate asset beta. beta. Reading 23: Capital Market Expectations • •

Frameworks for Developing Capital Market Expectations: 1. Specify the final set of expectations that are needed, including time horizon to which they apply 2. Research historical record i. collect macroeconomic and market info on 1. geographic area; or 2.  broad asset class 3. Specify the method(s) and/or model(s) that will be used and their information 4. Determine the best sources for information needs 5. Interpret the current investment environment using the selected data and methods, applying experience and judgment 6. Provide the set of expectations that are needed, documenting conclusions 7. Monitor actual outcomes and compare them to expectations, providing feedback   to improve the expectations-setting process Beta research: related to systematic risk and returns to systematic risk; development of capital market expectations Alpha research: related to capturing excess risk-adjusted returns by a particular strategy Good forecasts are: unbiased, objective and well researched efficient (reducing magnitude of forecast errors to a minimum) internally consistent • • •

Challenges in Forecasting: Limitations of economic data time lag of collection, processing and dissemination o changes in definitions and calculation methods (say CPI-U) o  re-basing indices Data measurement errors and biases Transcription errors: errors in gathering and recording o •

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Survivorship bias: data series reflect only survivors Appraisal (smoothed) data (say real estate or alternative investments): results in 1. calculated o correlations w/ other assets tend to be smaller in absolute value than true correlations; 2. true standard deviation of asset is biased downward Limitations of historical estimates: analysis should include discussion of what may be different from past o changes in technological, political, legal, and regulatory environments; disruptions such as wars change of regime: change of governing set of relationships creates nonstationarity (different parts of  o data series reflect different underlying statistical properties) o long data series:  risk that data cover multiple regimes  time series of required length may not be available  in order to get data series of required length, temptation is to use high-frequency data (weekly or daily): more sensitive to asynchronism (discrepancy in dating of observations that occurs b/c stale (out-of-date) data may be used in absence of current date) across variables, producing lower correlation estimates Ex Post Risk Can be a Biased Measure of Ex Ante Risk  ex post returns may reflect that didn’t materialize resulting in overstated estimates of ex ante returns o Biases in Analysts’ Methods: Data-mining bias: repeatedly “drilling” or searching dataset to find statistically significant pattern o Time-period bias: research findings that are sensitive to selection of starting and/or ending dates, may o  bias out-of-time period analysis Failure to account for conditioning info: analyst should condition forecasts on the state of economy to formulate most accurate expectations (say different betas in expansion eco nomies and recession economies) Misinterpretation of correlations: distinguish b/w exogenous and endogenous variables; o correlation may be spurious w/ no predictive relationship o  test w/ multiple regression variable significance  test using time series analysis w/ independent variables including lagged value of dependent variable, lagged value of tested variable and lagged value of control variables Psychological traps: anchoring trap : tendency to give disproportionate weight to first info received on topic o status quo trap: tendency to perpetuate recent forecasts—to predict no change o confirming evidence trap : bias that leads individuals to give greater weight to info that supports o existing or preferred point of view  examine all evidence w/ rigor   enlist an independent-minded person to argue against   be honest about motives overconfidence trap : tendency to overestimate accuracy of forecasts o o  prudence trap : tendency to temper forecasts so that they don’t appear extreme; to be overly cautious in forecasting o recallability trap: tendency of forecasts to be overly influenced by events that have left strong impression on person’s memory o model uncertainty: uncertainty whether selected model is correct  input uncertainty: uncertainty whether inputs are correct o

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Tools for Formulating Capital Market Expectations: Formal tools: established research methods amenable to precise definition and independent replication of  results Statistical methods: descriptive statistics; inferential statistics o •

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historical statistical approach: sample estimators (assuming stationarity) sample arithmetic mean total return or sample geometric mean total return as estimate of expected return sample variance as estimate of variance sample correlations as estimate of correlations  Shrinkage estimation: taking weighted average of historical estimate of parameter and some other parameter estimate based on analyst’s belief of weights target covariance matrix: selecting an alternative estimator of covariance matrix  Time-Series Estimators: forecasting a variable based on lagged variables good for short-term forecasts volatility clustering: tendency for large (small) swings in prices to be followed by large (small) swings of random direction o σ t 2 = β σ t 2−1 + (1 − β )ε t 2 ; beta is the rate of decay of the influence of the value of  volatility in one period on future volatility; epsilon is random noise  Multifactor Models: useful for estimating covariances: estimates of covariances b/w asset returns can be derived d erived using assets’ factor  o sensitivities may filter out noise o make it relatively easy to verify consistency of covariance matrix o factor covariance matrix: cross tabulations showing covariances / variances of factors Discounted Cash Flow Models:  equity markets: Gordon (constant) growth model  D  E ( Re ) = 1 + g  o  P 0 •

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number of shares outstanding; i is expected inflation; g is expected real total earnings growth; ΔPE is per period % change in P/E multiple; if share repurchases, then ΔS is negative and represents repurchase yield o expected income return: D/P – ΔS o expected nominal earnings growth return: i + g o expected repricing return: ΔPE o S&P 500 achieved 10.7% compound return from 1926-2001: 4.4% from income; 4.8% from nominal earnings growth; 1.5% from repricing Fed model: stock market overvalued if market’s current earnings yield is less than 10-yr  Treasury bond yield  fixed-income markets: YTM approach: use single discount rate Risk Premium Approach (build-up approach): risk-free rate plus one or more risk premiums that compensate investors for risky asset’s exposure to sources of priced risk   generally: E(R i) = R F + (Risk premium)1 + (Risk premium) 2 + ... + (Risk premium)K   fixed-income premiums: E(R   b) = Real risk-free interest rate + inflation premium + default risk   premium + illiquidity premium + maturity premium + tax premium •

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real risk-free rate: single-period interest rate for completely risk-free w/ no inflation; reflects time preference inflation premium: expected inflation: avg inflation rate expected over maturity plus  premium (or discount) for probability attached to higher inflation than expected (or  greater disinflation) default risk premium: sum of expected default loss plus nondiversifiable risk of default illiquidity premium: risk of loss to fair value if to convert to cash quickly maturity premium: increased sensitivity to change in market interest rates tax premium  equity risk premium: E(R e) = YTM on a long-term gov’t bond bo nd + equity risk premium Financial Market Equilibrium Models:  Black-Litterman: reverse-engineers the expected returns implicit in a diversified market  portfolio, combing them w/ investor’s own views in systematic way that take a ccount of  confidence  Singer-Terhaar approach: International CAPM: (assumes zero risk premium on currency): domestic risk-free rate plus risk premium based on asset’s sensitivity to world market portfolio and expected return on world market portfolio in excess of risk-free rate  E ( Ri ) =  R F  + β i [ E ( RM  ) − R F  ] •

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RPM/σM is the Sharpe ratio;  an asset class’s risk premium is therefore the expected excess return accruing to the asset class given its global systematic risk  illiquidity: ICAPM assumes perfect markets  illiquidity premium should be related to length of any period of lock-up  multi-period Sharpe ratio (MPSR): based on investment’s multiperiod wealth in excess of wealth generated by risk-free investment (i.e., compounded return over compounded cash return). market segmentation: (market integration: no impediments or barriers to capital mobility across markets);  use weighted average of risk premiums for completely integrated and completely segmented markets based on degree of segmentation developed markets estimated to have 80% integration weighting risk premium for fully integrated market will be beta times the world market risk premium (or the correlation times the country market standard deviation times the world market Sharpe Sh arpe ratio):   ERP M       ERP i =  ρ i ,M σ i    σ  M      

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covariance of two markets given betas to world markets:  ρ  σ   ρ  σ  2 = i ,M  i   j ,M    j σ M 2 =  ρ i ,M σ i ρ   j ,M σ   j cov cov i ,  j = β i β   jσ M  σ M  σ M 

global investable market (GIM): practical proxy for world market portfolio consisting of traditional and alternative asset classes w/ sufficient capacity to absorb meaningful investment Survey and Panel Methods:  survey method: of expectations setting involves asking group of experts for expectations 2002 survey: 2 to 2.5% equity risk premium; other 3.9% 3 .9% ex pert group queried   panel method: if survey involves a stable expert Livingston Survey: covers U.S. GDP growth, CPI and PPI inflation, unemployment rate, and 3-month T-bill and 10yr T-bond yields Judgment: economic and psychological insight to improve forecasts  checklists •

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Economic Analysis: Business cycle analysis: short-term inventory cycle (2-4 yrs); longer-term business cycle (9-11 years) chief measurements of economic activity: o  GDP: consumption, investment, change in inventories, gov’t spending and exports less imports  output gap: difference b/w GDP trend (potential GDP) and actual; affects inflation  recession: two successive quarterly GDP declines inventory cycle: caused by companies trying to keep inventories at desired levels as expected level of  o sales changes  up phase: businesses confident and increase production  down phase: business cuts back production to reduce inventories ratio: when moved down, economy likely to be strong in next few few quarters, as  inventory / sales ratio:  businesses try to rebuild; when ratio moved sharply up, period of economic weakness can be expected however, downward trend from improved technology (“just in time” inventory management); but more visibility so sharper changes o  business cycle: 1. initial recovery; 2. early upswing; 3. late upswing; 4. slowdown; 5. recession  1. initial recovery: short phase (few months) when econo my picks up from slowdown; business confidence rising, though consumer confidence still low from unemployment; stimulatory economic policies; usually upswing in inventory cycle; inflation still falling and output gap still large gov’t bond yields may still be falling (matching declining inflation) or bottoming; stock market may rise sharply, w/ demand for cyclical and riskier assets  2. Early upswing (1 yr to several years): confidence up and momentum in economic activity, w/o overheating or sharply higher inflation; consumers prepared to borrow and spend;  businesses build inventories and investment, w/ higher sales and increased capacity use; profits rise from lower unit costs; short rates starting to rise as stimulus withdrawn; longer bond yields stable or rising stocks still trending up  3. Late upswing: output gap has closed and danger of overheating; high confidence and low unemployment; high growth; inflation starts to pick up w/ accelerating wages interest rates rising from tighter monetary policy; pressure on credit markets from heavy  borrowing; central banks aiming for soft landing  bond yields rising •

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stock markets rising still but nervously; volatile 4. Slowdown (few months to 1 year): economy slowing from rising interest rates; vulnerable to shock; business confidence wavers; inflation still rising; businesses reduce inventories (inventory correction); short-term interest rates are high and rising to peak   bonds top out at first sign of slowing economy, then rally sharply (yields fall) yield curve inverts stock market falls, w/ utilities and financial services performing best 5. Recession (6 mos to yr): large inventory pullback and sometimes large decline in business investment; consumers reduce big-ticket expenses; upon recession confirmation, monetary  policy cautiously eased; consumer and business confidence decline; profits drop sharply; financial system may be stressed by bad debts, so cautious lending; major bankruptcies and uncovered fraud; maybe financial crisis; maybe quickly risking unemployment short-term interest rates and bond yields drop; stock market begins to rise at later stages (b/f recovery) trends affecting business cycle: growing China aging populations deregulation oil crises financial crises •

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Five Phases of Business Cycle Phase Economy

1. Initial recovery

Inflation still declining

Healthy economic growth; inflation remains low 3. Late Inflation gradually upswing  picks up 4. Slo Slowd wdow own n Infl Inflat atio ion n cont contin inue uess to accelerate; inventory correction begins 5. Reces cession Pro Produc duction declines; inflation  peaks

Fiscal & Monetary Policy Stimulatory fiscal  policies

2. Early upswing

o

Policy becomes restrictive

Confidence

Capital Ma Markets

Confidence starts to rebound Increasing confidence

Short rates low or declining; bond yields  bottoming; stock prices strongly rising

Boom mentality Confidence drops

Confidence weak 

Short rates moving up; bond yields stable to up slightly; stock prices trending upward Short rates rising; bond yields rising; stocks topping out, often volatile Short-term interest rates peaking; bond yields topping out and starting to decline; stocks declining Short rates declining; bond yields dropping; stocks bottoming and then starting to rise

Inflation and deflation in the business cycle:  central bank orthodoxy: central bank policymaking must be independent so monetary policy not too loose central bank should have inflation target for discipline and to set expectations central banks should use monetary policy to prevent overheating or recession  deflation: 1. undermines debt-financed investments (resulting in panicked asset sales); 2. limits ability of central bank to conduct monetary policy (liquidity trap) • • •

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o

inflation should result in higher profits and higher stock prices, but too high results in efforts to cool down the economy, resulting in lower stock prices Market Expectations and the Business Cycle:  “growth recession”: slowdown in growth, but not recession; more likely if: upswing was relatively short or mild no bubble or severe overheating in stock or property markets inflation relatively low, so central bank willing to cut interest rates quickly world economic and political environments are positive • • • •

Inflation/Deflation Effects on Asset Classes Cash Bonds

Equity

Inflation at Short-term or below yields steady expectations or declining. [Neutral]

Yield levels maintained; market in equilibrium. [Neutral]

Inflation Bias toward above rising rates. expectations [Positive]

Bias toward higher yields due to a higher inflation  premium. [Negative]

Deflation

•

Bias toward 0% shortterm rates. [Negative]

Bullish while market in equilibrium state. [Positive]

High inflation a negative for financial assets. Less negative for  companies/industries able to pass on inflated costs. [Negative] Purchasing power increasing.  Negative wealth effect Bias toward steady to lower  slows demand. rates (may be offset by Especially affects assetincreased risk of potential intensive, commoditydefaults due to falling asset  producing (as opposed to  prices). [Positive] commodity-using), and highly levered companies. [Negative]

Real Estate/ Other Real Assets Cash flow steady to rising slightly. Returns equate to to long-term average. Market in general equilibrium. [Neutral] Asset values increasing; increased cash flows and higher expected returns. [Positive]

Cash flows steady to falling. Asset prices downward pressure. [Negative]

Evaluating Factors that Affect the Business Cycle: consumers; business; foreign trade; gov’t activity: monetary and fiscal policy o consumer spending: 60 – 70% of GDP  retail sales; store sales data; consumer consumption data can be erratic; affected by weather and an d holidays  after-tax income: wages, inflation, tax changes, employment growth non-farm payrolls weekly new unemployment claims savings rate o  business spending: business investment and spending on inventories  volatile: say decrease by 10-20% for recession and increase by same during upswing  inventories: rising may mean businesses are confident (early stages of inventory upswing), but rise may be involuntary from lower sales (late stages of inventory cycle)   purchasing managers index (PMI); ISM survey of non-manufacturing companies o foreign trade: 30-50% of GDP in smaller economies; 10-15% 10 -15% in larger  o gov’t policy: 1. try to control business cycle; 2. try to moderate inflation; 3. incumbents try to affect  policy during elections •

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monetary policy: monetary authorities watch: 1. pace of econ omic growth; 2. amt of excess capacity still available; 3. level of unemployment; 4. rate of inflation relative interest rates matter: in relation to neutral interest rates (4% argued in U.S.) Taylor Rule: target short-term interest rate based on rate of growth of econ omy and inflation: say: o  Roptimal  =  Rneutral  + 0.5 × ( GDPg   forecast  − GDPg trend  + 0.5 × ( I   forecast  − I t arg et  • •

money supply trends: long run stable relationship b/w growth of money supply and nominal GDP if interest rates at zero, can then 1. push cash (bank “reserves”) directly into banking system; 2. devalue currency; 3. promise to hold short-term rates low for extended  period; 4. bank to buy assets directly from private sector. fiscal policy: change spending; cut or raise taxes; changes, not levels, are important; and deliberate changes (rather than changing levels resulting from fluctuating tax revenues based on economy) •

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Policy Mix and the Yield Curve

Monetary Policy

Loose Tight

Fiscal Policy Loose Yield cu curve st steep Yield curve flat

Tight Yield curve mo moderately steep Yield curve inverted

Economic Growth Trends: consumer impacts: consumption and demand o  permanent income hypothesis: consumers’ spending behavior is largely determined by their long-run income expectations consumer trends usually stable or even countercyclical over business cycle (may reduce savings if  o temporary CF reductions to maintain long-term spending patterns): spending rises less than income rises and falls less than income falls Decomposition of GDP Growth and Its Use in Forecasting: growth from changes in employment (growth from labor inputs) o  growth in size of potential labor force  growth in labor force participation rate growth from changes in labor productivity o  growth from capital inputs  growth in total factor productivity (TGP growth): technical progress Gov’t Structural Policies: gov’t policies that affect limits of economic growth and incentives w/i private sector; pro-growth policies: 1. Fiscal policy is sound o  large budget deficit leads to current account deficit (“twin deficits” problem), leads to  borrowing abroad; when foreign debt too high, usually requiring devaluing currency  high inflation if deficit is financed by printing  crowds out private sector  2. Public sector intrudes minimally on the private sector: o  allow marketplace to provide the right incentives to individuals  labor market rules raise structural level of unemployment 3. Competition w/i the private sector is encouraged: causes efficiency and productivity growth; o reduction of trade tariffs and barriers; advances in networking technology; openness to foreign investment; (but competition may reduce stock market valuations from lower profits) •

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o o

4. Infrastructure and human capital development are supported: health and education infrastructure 5. Tax policies are sound: simple, transparent, and rarely altered tax rates; low marginal tax rates; very  broad tax base

Exogenous Shocks: from changes in gov’t policy unexpected breakup of OPEC “peace dividend” from fall of Berlin Wall new products, markets and technologies Oil shocks: sudden rises affects consumers’ income and reduces spending; inflation rises, maybe offset by contractionary effect of higher oil prices restricting employment and opening up output gap Financial Crises: bank lending and investor confidence • • • • •

•

International Interactions: Macroeconomic linkages: foreign demand for exports; cross-border direct business investment; but no t  perfectly integrated Interest Rate / Exchange Rate Linkages: formal or informal exchange rate links; unilateral pegs; Emerging Markets: o Essential Differences b/w Emerging and Major Economies:  need higher rates of investment than developed countries in physical capital and infrastructure and in human capital   periodic crises from managing foreign debt required for investment  volatile political and social environment  often relatively small and concentrated in areas such as commodities or narrow range of  manufactured goods; may rely heavily on oil imports o Country Risk Analysis Techniques:  emerging bonds: risk of country being unable to service debt  stock: growth prospects and vulnerability to surprises  Checklist: 1. How sound is fiscal and monetary policy? ratio of fiscal deficit to GDP: persistently persistently above 4% is concern; ratio of debt to GDP: 70-80% extremely vulnerable 2. What are the economic growth prospects for the economy? if slow growth w/  population growth, likely political stress from falling per capital income o Economic Freedom Index 3. Is the currency competitive, and are the external accounts under control? con trol? current account deficit o 4. Is external debt under control? control? if reluctance to lend new money, money, may be exodus of  capital; ratio of foreign debt to GDP: 50% is dangerous; d angerous; debt to current account receipts: 200% in danger zone 5. Is liquidity liquidity plentiful? foreign exchange reserves in relation relation to trade flows and shortterm debt; ratio of reserves to short-term debt (maturing w/i 12 mos): under 100% is risky 6. Is the political political situation supportive of required required policies? whether gov’t will implement necessary adjustment policies: cutting budget deficit, privatization, ending monopolies •

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Economic Forecasting: econometric models: o limitations: •

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finding adequate measures for real-world activities and relationships to be modeled  measurement error   relationships may change over time from changes of structure of economy o constrains the forecaster to a certain degree of o f consistency and also challenges the modeler to reassess  prior views based on what the model concludes forecasts upturns much better than recessions o leading indicators: lagging, coincident and leading diffusion index: how many indicators pointing up and how many down o world: o  OECD Composite Leading Indicators Europe: o  Eurozone Harmonized Index of Consumer Prices  German Industrial Production  German IFO Business Survey  French Monthly Business Survey o Asia Pacific:  Tankan Survey  China Industrial Production South America: o  Brazil Industrial Production o  North America:  Conference Board’s Index of Leading Economic Indicators: 1. Avg weekly hrs, manufacturing 2. avg weekly initial claims for unemployment insurance 3. manufacturers’ new orders, consumer goods and materials 4. vendor performance, slower deliveries diffusion index 5. manufacturers’ new orders, non-defense capital goods 6. building permits, new private housing units 7. stock price, 500 common stocks 8. money supply, M2 9. interest rate spread, 10-yr Treasury bonds less federal funds 10. index of consumer expectations three consecutive mos of increases, or 3 consecutive mos of decreases, signaled upturn or downturn in economy w/i 3 to 6 mos checklists: subjective o ex: o 1. Where in the cycle is the economy now? Aggregate activity review previous data on GDP growth and a nd its components (consumer spending, business investment, inventories, net exports, and gov’t spending) how high is unemployment relative to estimates of “full employment”? has unemployment been falling? How large is the output gap? What is the inventory position? Where is inflation relative to target, and is it threatening to rise? inflation 2. How strong will consumer spending be? Consumer   Review wage/income patterns. Consumer   •

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How fast will employment grow? How confident are consumers? Consumer confidence indices. 3. How strong will business spending be? Review survey data (e.g., purchasing managers indices.) Review recent capital goods orders. Assess balance sheet health of companies. Assess cash flow and earnings growth trends. Has the stock market been rising? What is the inventory position? Low inventory/sales ratio implies GDP strength. 4. How strong will import growth be? Exchange rate competitiveness and recent movements. Strength of economic growth elsewhere. 5. What is the government’s fiscal stance? 6. What is the monetary stance? Review recent changes in interest rates. What do real interest rates tell us? What does the Taylor rule tell us? Monetary conditions indices (i.e., trends in asset prices and exchange rate). Money supply indicators. 7. Inflation How fast is inflation rising, or are prices falling?

Consumer   Consumer   Business Business Business Business Business Business Business Government Government Government Government Central bank   Central bank   Central bank   Central bank   Central bank   Central bank   Inflation Inflation

Advantages and Disadvantages of 3 Approaches to Economic Forecasting Advantages Disadvantages Econometric Models Approach Models can be quite robust with many factors used that Most complex and time-consuming to formulate. can approximate reality. Data inputs and relationships not easy to forecast and not Once models are built, new data may be collected and static. consistently used w/i models to quickly generate output. Requires careful analysis of output. Provides quantitative estimates of the effects on the Rarely forecasts recessions well. economy of changes in exogenous variables. Leading Indicator-Based Approach Usually intuitive and simple in construction. Historically, has not consistently worked, as relationships May be available from third parties.  between inputs are not static. May be tailored for individual needs. Can provide false signals. A literature exists on the effective use of various third party indicators. Checklist Approach Limited complexity. Subjective. Flexible: allows structural changes to be easily Time-consuming. incorporated Complexity has to be limited due to the manual nature of  the process.

Using Economic Info in Forecasting Asset Class Returns: Cash and Equivalents: reflects markets expectations of rates over maturity period—forecast economy and the central bank’s reaction to the economy  Nominal Default-Free Bonds: components of yield are (i) growth rate o f GDP and supply and demand for  capital and (ii) forecast inflation over period. •

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watch business cycle and short-term interest rates  news of stronger economic growth usually makes bond b ond yields rise (prices fall) b/c implied greater demand for capital and possibly higher inflation  rise in short term rates often leads to rise in longer-term bond yields; but may also be expected to slow economy and bond yields could fall b anks will achieve inflation targets, bond yields should not  if bond markets expect central banks change on inflation expectations but bu t could fluctuate w/ short rates  assess future effects of inflation Defaultable Debt: spread over Treasuries in part represents market’s perception of default risk  spreads tend to rise during recession b/c companies under stress from weak business conditions and o usually higher interest rates during strong economic growth, spreads narrow as fears of default decline o Emerging Market Bonds: sovereign debt of nondeveloped countries; o country risk: economic and political factors, including whether has power to follow necessary policies to stabilize economy; compared to spreads over domestic Treasuries of similarly rated domestic corporate debt Inflation-Indexed Bonds: fixed coupon plus adjustment equal to change in consumer prices o

•

•

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Macroeconomy and Real Yields Economic Observation Economic growth rising (falling) Inflation expectations rising (falling) Investor demand rising (falling) •

Effect on Real Bond Yields Rise (fall) Fall (rise) Fall (rise)

Common Shares: consider (i) company earnings and (ii) interest rates, bond yields and liquidity o  price of oil; demand for airline travel o Economic factors affecting earnings: long term: aggregate company earnings mainly determined by trend rate of growth of economy  labor force growth; level of investment; rate of labor productivity growth overinvestment; gov’t overregulation; political instability; bursting of asset bubble  share of profits in GDP varies w/ business cycle and influenced by: final sales, wages, capacity utilization, interest rates recession: reduced sales w/ burden of fixed costs; some companies (food companies) may not change in earnings in recession, so may go up early stages of economic upswing: earnings recover strongly: capacity utilization and increasing employment; wages modest; efficiency gains from recession; later upswing: wage growth; profits contract cyclical stocks: sensitive to business cycle from large fixed costs and o  pronounced sales cycle (car manufacturers and chemical producers) P/E Ratio and the Business Cycle: o  high and rises when earnings expected to rise  low and falling if earnings falling   but may anticipate future earnings recovery (Molodovsky effect)  high inflation tends to depress (past P/Es must be compared after controlling for inflation) Emerging Market Equities: ex post risk premiums in U.S. do llar terms positively correlated w/ o expansion phases in G-7 economies (industrial production): trade, finance, direct sectoral linkages  country analysis  sector-specific research Real Estate: growth in consumption, real interest rates, term structure and unex pected inflation •

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Currencies: current account balance: import more --> currency depreciates o strong domestic growth and opening of new industries: rise in fdi --> currency appreciates o volatility from inflows and outflows for stocks, bonds and short-term instruments o high interest rates: usually high inflows --> currency appreciates o o low interest rates ... currency usually depreciates o however: high interests may be result of slowing economy --> cu rrency depreciates o approaches to forecasting:  PPP: exchange rate should offset any difference in inflation rates (useful for long run: say 5 yrs)  Relative Economic Strength: investment flows: strong economic growth creates attractive investment opportunities (say high short-term deposit rate) --> currency appreciates if particularly high interest rates, speculators less likely to short currency b/c likely to strengthen from higher rates converse: Japan’s carry trade as a result of low interest rates  Capital Flows: focuses on expected capital flows, particularly long-term such as equity investment and fdi; inflows --> currency appreciates long-term capital flows may reverse usual relationship b/w short rates and currency: central bank may want to raise interest rates to respond to weak currency that is threatening to stimulate economy too much and boost inflation, effect may actually be to push currency lower; reduced effectiveness of monetary policy.  Savings-Investment Imbalances: (may explain long-term equilibrium departures): if private sector or gov’t currency-related trends change (re current accounts), current account position must change too and the exchange rate moves to help achieve that. currency needs to stay reasonably strong as long as domestic investment exceeds savings; if economy becomes weak enough enoug h at this point and domestic investments no longer exceed domestic savings, then currency will also weaken Gov’t intervention: difficulty in attempts to control b/c 1. total value o f foreign exchange trading, in o excess of US$1 trillion daily, is large relative to total foreign exch ange reserves of major central banks combined; 2. gov’ts just another player in the market; 3. experience is not encouraging in the absence of capital controls (unless willing to move interest rates and other policies). •

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Info Sources for Economic Data and Forecasts: Selection of Data Sources for Researching U.S. Markets Categories of  Factor Measures Economic Interest Economic fundamentals Consumers

Business

Central bank

Measures of economic output/growth (e.g GDP, industrial production) General Price level stability Employment/unemployment Measures of consumption/income Meas Measur ures es of savi saving ngs, s, inves investm tment ent,, and and leve levera rage ge Measures of sentiment Measures of profitability Measures of productivity Industry price level stability Capacity utilization rates Measures of monetary policy 40963581.doc 41 of 114

Data Use: LT +

+ + + + + + + + +

Data Use: ST

Data Source

www.bea.gov Bloomberg Bloomberg www.bea.gov

+ + +

U. of Michigan Survey www.bea.gov Federal Reserve Bank   Internal or third-party research; Trade pub. www.stls.frb.org

Government

Economic technical factors Market fundamentals

Market technical factors Other: unique; social;  political

General price level stability (inflation) Assessment of central bank independence Fiscal policy Assessment of exchange rate stability/trends

+

Measures of political stability Assessment of legal system’s ability to protect assets (including intangible assets) and ability to settle disputes (due process) Capital flows Sector/industry supply and demand Rates of return Valuation trends (e.g., equity P/E multiples) Asset class price volatility: Large-cap equities Corporate bonds vs. overall market Short sovereign debt Exchange rate movements Ratio of advances/declines in equity market Corporate bond issuance (market yield) Demographic influences Seasonal patterns of consumption Current account trends; net exports versus imports

+ +

+ +

+ + + +

+ + + +

Bloomberg Internal analysis Congressional Budget Office; Bloomberg; Internal; www.wto.org Internal analysis Internal analysis

+ + + +

Internal / third-party research; Trade publications Relative (industry) internal research; Third-party research; Trade publications

+ +

+

+ + +

+ + + + +

Reuters; Internal research Internal research Third-party; Trade pub. Bloomberg

also: www.imf.org www.worldbank.org www.oecd.org www.federalreserve.gov www.ecb.int www.bankofengland.co.uk  www.boj.or.jb/en www.bis.org www.nber.org Reading 24: Macroanalysis and Microvaluation of the Stock Market Economic series and the economy: econo my: NBER has classified numerous economic series as: leading, coincident or lagging: leading: peaks and troughs occur before aggregate economic activity stock market is a good leading indicator of the economy: expectations of CFs; response to other  o leading indicators cyclical indicator approach: expansion and contraction can be identified by movements reflected in o specific economic series coincident: peaks and troughs coincide lagging: peaks and troughs lag selected series: influence economy but don’t neatly fit into three above: U.S. balance of payments; federal surplus/deficit composite series: combination of series ratio series: coincident over lagging sometimes leads leading or otherwise diverges analytical measures: •

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diffusion index: say % of reporting units in a series indicate a given result  trend of diffusion index always reaches peak or trough prior to index rates of change: (momentum) o comparison w/ previous cycles: slower or faster  o Limitations: false signals: sudden reverses o currency of data and revisions (esp if revisions are other direction) o not all economic sectors represented (e.g., service, import-exports, int’l) o o

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Conference Board’s Index of Leading Economic Indicators: o 1. Avg weekly hrs, manufacturing o 2. avg weekly initial claims for unemployment insurance 3. manufacturers’ new orders, consumer goods and materials o 4. vendor performance, slower deliveries diffusion index o 5. manufacturers’ new orders, non-defense capital goods o 6. building permits, new private housing units o 7. stock price, 500 common stocks o 8. money supply, M2 o 9. interest rate spread, 10-yr Treasury bonds less federal funds o 10. index of consumer expectations o coincident: 1. number of employees on nonagricultural payrolls o 2. personal income less transfer payments, expressed in 1992 dollars o 3. Index of industrial production o 4. Manufacturing and trade sales, expressed ex pressed in 1992 dollars o lagging: 1. average duration of unemployment o 2. ratio of manufacturing and trade inventories to sales o 3. percentage change in labor cost per unit of output in manufacturing o 4. average prime rate charged by banks o 5. commercial and industrial loans outstanding o 6. ratio of consumer installment credit outstanding to personal income o 7. change in consumer price index (inflation rate) for services o

Center for International Business Conditions Research (CIBCR) (at Columbia): Long-Leading Index Leading Employment Index Leading Inflation Index International Leading Indicator Series • • • •

Surveys of Sentiment and Expectations: University of Michigan Consumer Sentiment Index; Conference Board Consumer Confidence Index Goldman Sachs Financial Conditions Index: increase in index indicates tightening / rising interest rates Relationship b/w money supply and stock prices: necessary to forecast unanticipated changes in money supply growth Inflation and interest rates: strong relation; (spread changes over time) 40963581.doc 43 of 114

Inflation, Interest Rates, and Stock Prices: 1. positive scenario: negative effect of interest rate increase (required rate of return) partially or wholly offset  by increase in growth of earnings and dividends (inflation pass through) 2. mild negative scenario: higher costs and not able to pass through, so higher h igher k and flat g 3. very negative scenario: k increases; g declines •

• •

Microvaluation: 1. DDM; 2. FCFE; 3. earnings multiplier technique; 4. other relative valuation ratios DDM: discount the dividends: k: nominal risk-free rate: 10-yr Treasury note; 30-yr Treasury bond; o k: equity risk premium: geometric for long-term: say 6.5% from Ibbotson Associates; other b/w 2% o and 6% g: current and expected changes in growth; o   b x ROE ROE: NI/Equity = NI/Sales x Sales / Total assets x Total assets / equ ity so w/ dividend estimate and k and g, can them estimate market value; further can estimate implied o spread from current market prices can obtain implied k: k = D/p + g o FCFE: = NI + Depr – capex – change in working capital – principal debt repayments + new debt issues single stage; two-stage o estimate g from historical (say same in DDM) o estimate k same as DDM o Earnings multipliers: estimate of spread: o  P = D1 / (k-g)  P/D1 = 1 /(k-g)  D1/P = k-g o 1. estimate future EPS for stock series; 2. estimate earnings multiplier based on k-g spread •

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Expected EPS: 1. estimate sales per share based on GDP: single variable regression 2. estimate operating profit margin: profit / sales; (say EBITDA for operating profit) o can estimate net profit margin, or  o can estimate net before tax profit margin and then estimate taxes, or  o estimate EBITDA profit margin o affected by: 1. capacity utilization rate; 2. unit labor cost; 3. rate of inflation; 4. foreign competition 3. estimate depreciation per share for next year: estimate PPE and then use historical depr rate 4. estimate interest expense for next year: estimate 1. amt of total assets for firm based on expected total asset turnover and 2. expected capital structure based on avg total debt to total assets 5. estimate corporate tax rate for next year: evaluate current tax rate and recent legislation • •

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Estimating the Stock Market Earnings Multiplier:  P 

=

 D1  E 1

•

determinants: use long-term estimates of k and g:

•

use long-term estimate of D/E: use time-series analysis then relate to earnings estimate can estimate direction of change from current, or  specific value from specific estimates of D/E, k and g.

 E 

o

•

Other Relative Valuation Ratios: P/BV; P/CF; P/S. 40963581.doc 44 of 114

k  − g 

Microvaluation of World Markets: 1. basic valuation model and concepts apply globally 2. input values can vary dramatically 3. valuation of nondomestic markets be more onerous: say forecasting exchange rates for hedging • • •

Sources of economic info: www.morganstanley.com www.globalinsight.com www.yardeni.com www.whitehouse.gov/fsbr/esbr.html www.federalreserve.gov www.worldbank.org www.bankamerica.com www.spglobal.com www.bis.org/cbanks.htm www.nabe.com www.conference-board.org www.federalreserve/gov/pubs/bulletin www.bea.doc.gov/bea/pubs.htm www.stats.bls.gov www.cbo.gov www.whitehouse.gov/cea www.gpoaccess.gov/indicators/browse.html www.census.gov/csd/qfr  www.access.gpo.gov/eop www.census.gov/statab/www/ www.federalreservebanks.org www.stlouisfed.org research.stlouisfed.org/fred2/ www.phil.frb.org/econ/ www.eiu.com www.oecd.org www.economist.com un.org/depts/unsd/sd_economic.htm www.un.org www.imf.org • • • • • • • • • • • • • • • • • • • • • • • • • • • • • •

Reading 25: Dreaming with BRICs: the Path to 2050 BRICs have larger US$GDP than G6 G 6 in less than 40 yrs; currently only 15% Have less capital, so higher returns on capital, resulting in higher growth of capital stock  Technological catch up. Countries grow richer on back of appreciating currencies; convergence to PPP. GDP Growth: growth in employment; growth in capital stock; technical progress/TFP. 40963581.doc 45 of 114

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Maybe lower convergence in India and Brazil than Russia and China b/c lower education levels and poorer  infrastructure Maybe 1/3 of increase in US$GDP of BRICs from rising currencies and 2/3s from faster growth

Conditions for growth: Robert Barro: o Higher schooling o Higher life expectancy Lower fertility o Lower gov’t consumption o Better maintenance of rule of law o Lower inflation o Improvements in terms of trade o Macro stability: price stability (fiscal deficit reduction, tighter monetary policy, exchange-rate realignment) Institutions: efficient legal system, functioning markets, health and education systems, financial institutions and gov’t bureaucracy Openness: trade and fdi Education: skilled workers •

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Reading 26: Asset Allocation Strategic Asset Allocation: establish exposures to IPS-permissible asset classes by integrating investor’s return objectives, risk tolerance, and investment constraints w/ long-run capital market expectations. result is the Policy Portfolio In long run, diversified portfolio’s mean returns are reliably related to systematic risk exposures. Strategic asset allocation specifies investor’s desired exposures to systematic risk.  b/c investors in aggregate are the market and costs do not net out across investors, return on avg actively managed dollar should be less than return on avg passively managed dollar after costs • • • •

Tactical asset allocation (TAA): short-term adjustments to asset-class weights based on short-term expected relative  performance among asset classes. creates active risk  •

Asset-Only (AO) vs. Asset/Liability Management (ALM): ALM: explicitly modeling liabilities (and quasi-liabilities) and adopting optimal asset allocation in relationship to funding liabilities; concern for net returns and risk  Cash flow matching: exact matching: use bonds to match liabilities and quasi-liabilities o Immunization: structures investments in bonds to match (offset) weighted-avg duration of liabilities o  riskier than cash flow matching as duration is first-order approximation of interest rate risk  o favored by:  investor w/ below-avg risk tolerance  if have high penalties for not meeting liabilities  if market value of liabilities interest rate sensitive  if risk taken in investment portfolio limits investor’s ability to profitably take risk in other  activities  if legal and regulatory reqs and incentives favor holding fixed-income securities  if tax incentives favor holding fixed-income securities AO: no explicit liability modeling; concern for absolute return and risk  •

•

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Black-Litterman model: take global market-value-weighted asset allocation (Market equilibrium  portfolio) as default and then incorporate deviate from weights reflecting views on asset classes’ expected returns and strength of views

Dynamic vs. Static approach: dynamic: link optimal investment decisions to all future time periods static: do not consider links b/w optimal decisions at d ifferent time periods • •

Characteristic Liability Concerns of Various Investors Type of Investor Type of Liability (Quasi-Liability)

Individual Pension plans (defined  benefit) Pension plans (defined contribution) Foundations and endowments Life insurance companies  Non-life insurance companies Banks

Penalty for Not Meeting

Taxes, mortgage pmts (living expense, wealth accumulating targets) Pension benefits

Varies High, legal and regulatory Varies

(Retirement needs)

Spending commitments, capital project commitments Death proceeds, annuity payments, return guarantees on investment products Property and liability claims Deposits

High Very high, legal and regulatory Very high, legal and regulatory Very high, legal and regulatory

Asset Allocation Approach in Practice AO most common; ALM ALM AO

Integrated w/ individual’s asset allocation approach AO ALM ALM ALM ALM

Risk objectives: 2 Investor’s expected utility for asset mix: U m =  E ( Rm ) − 0.005 R Aσ m ; E is expected return for mix; R is investor’s risk aversion (1 to 10?); σ2 is variance of return for mix shortfall risk: risk that fall below minimum during time downside risk: risk relating to losses or worse than expected outcomes only (also semivariance and target semivariance) Roy’s safety-first criterion: optimal portfolio minimizes probability over stated time ho rizon that portfolio •

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return will fall below some threshold level: SFRatio •

=

 E ( R P  ) − R L

σ  P 

could specify maximum probability of not meeting a return threshold

Behavioral Influences on Asset Allocation: loss aversion: worry about avoiding losses more than gains; risk-seekers when faced w/ losses (could use shortfall risk criterion or ALM) Mental accounting: associate different level of risk tolerance depen ding on mental account regret avoidance: may promote diversification; may limit divergence from peers’ avg asset allocation •

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Selection of Asset Classes: Criteria for specifying asset classes: 1. assets w/i asset class should be relatively homogenous o 2. asset class should be mutually exclusive o •

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3. asset classes should be diversifying 4. asset classes as group should make up preponderance of world investable wealth o 5. asset class should have capacity to absorb significant fraction of investor’s portfolio w/o seriously o affecting portfolio’s liquidity Traditional asset classes: domestic common equity o domestic fixed income o non-domestic (international) common equity (maybe developed-emerging distinction) o non-domestic fixed income (maybe developed-emerging distinction) o real estate (maybe including other alternative investments) o cash and cash equivalents o o (consider also tax concerns) o

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test for adding asset class:

 E ( Rnew ) − R F 

σ new

  E ( R p ) − R F     Corr  ( Rnew , R p ) >    σ   p    

also consider following for whether to add international assets:  currency risk   increased correlations in times of stress  emerging market concerns alternative assets: heterogeneous; high diligence costs

Steps in Asset Allocation: asset allocation review: o (AO is special case where liabilities equal 0) •

Capital Market Conditions Investor’s Assets, Liabilities, Net Worth, and Risk Attitudes | | Prediction procedure Investor’s Risk Tolerance Function | | Expected Re Returns, Ri Risk, aan nd Co Correlations Investor’s Ri Risk To Tolerance | | Optimizer  | Investor’s Asset Mix | Returns | (back to top) Optimization: mean-variance approach o identify efficient frontier (part of minimum variance frontier bordered on the bottom by global minimum variance portfolio) mean-variance optimization (MVO): o  unconstrained MVF: asset-class weights sum to 1. (allows for short positions)  sign-constrained MVF: no short-positions and sum to 1. corner portfolios: 1. portfolios hold identical assets and 2. rate of change of asset weights in moving from one portfolio to another is constant. corner portfolio theorem: In a sign-constrained optimization, the asset weights o of any minimum-variance portfolio are positive linear combination of  •

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corresponding weights in two adjacent corner portfolios that bracket it in terms of expected return (or standard deviation of return) find adjacent portfolios for desired return and then weight such two portfolios to o obtain return; then weight underlying assets by such weights most important inputs in mean-variance optimization are expected returns: highly sensitive to small changes in inputs for cash equivalents: risk-free rate suggests single-period perspective; reported positive standard deviation suggest multiperiod perspective capital allocation line is the line from the risk-free rate an d tangent to efficient frontier  may not be able to use tangency portfolio if have restraint on borrowing •

Selected Extensions to Mean-Variance Approach Concern Adaptation A. Downside risk 1. Mean-semivariance 2. MVO w/ shortfall constraint 3. MV surplus optimization B. Tracking risk relative 5. MVO w/ constraints on asset weights relative to to benchmark   benchmarks 6. Mean-tracking error (MTE) optimization 7. Mean-variance-tracking error (MVTE) optimization C. Changing correlations 9. MVO w/ adjusted correlation matrix in times of stress •

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Source Markowitz(1959) Leibowitz and Henriksson (1989) Leibowitz and Henriksson (1988) Ad hoc practice

Roll (1992) Chow (1995) Chow et al. (1999)

Resampled Efficient Frontier: set of resampled efficient portfolios resampled efficient portfolio: for given return rank, portfolio defined by avg weights on each asset o class for simulated efficient portfolios w/ return rank (after rerunning optimization many times using range of inputs around point estimates) (if asset class shows up at all in any run, will show up on resampled efficient frontier, however small) o (lacks theoretical underpinning) o Black-Litterman Approach: o unconstrained Black-Litterman (UBL) model: taking weights of asset classes in global benchmark as neutral starting point, and adjust to reflect views according to Bayesian procedure (allowed to sell short) Black-Litterman (BL) model: combines reverse optimization w/ investor’s views on expected returns o systematically w/ confidence of views (no short sales)  reverse optimization: reverse engineers expected returns implicit in diversified market portfolio

Steps in BL Model Step 1. Define equilibrium market weights and covariance matrix for all asset classes 2. Back-sol Back-solve ve equilibri equilibrium um expected expected returns returns 3. Ex Expr pres esss view viewss and and con confi fide denc ncee

4. Calculate the view-adjusted market equilibrium returns 5. Run Run mean ean-variance opt optimizati ation

Purpose Inputs for calculating equilibrium expected returns

Form neutral neutral starting starting point point for for formula formulating ting expecte expected d returns returns Ref Reflect ect inves nvesttor’s or’s expe expect ctat atio ions ns for vari variou ouss asse assett clas classe sess; the conf confid iden ence ce level assigned to each view determines the weight placed on it Form the expected return that reflects both market equilibrium and views Obtain ain ef efficient frontier an and po portfoli olios

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Monte Carlo Simulation: simulation that imitates an asset allocation’s real-world operation in an investments laboratory ALM: focuses on surplus efficient frontier  o surplus efficient frontier is bordered on bottom by minimum surplus variance (MSV) at which point strategy might be cash flow matching or immunization o surplus beta decision: increment of risk accepted abo ve the MSV portfolio o ALM w/ simulation:  1. determine surplus efficient frontier and set of efficient portfolios among range  2. conduct Monte Carlo simulation for each proposed asset allocation and evaluate  3. choose most appropriate. o Surplus objective function’s expected value for particular asset mix for specified risk aversion: 005 R Aσ 2 ( SR m ) U m ALM  =  E ( SR m ) − 0.005 Experience-Based Approaches: 1. 60/40 stock/bond asset allocation is appropriate or at least a starting point for an average investor’s o asset allocation o 2. Allocation to bonds should increase w/ increasing risk aversion o 3. Investors w/ longer time horizons should increase their allocation to stocks o 4. A rule of thumb for % allocation to equities is 100 minus age of investor 

Implementing the Strategic Asset Allocation: approaches: o  passive investing active investing o semi-active investing or enhanced indexing o some other combination o instruments: tracking portfolio of cash market securities o derivatives: swap o derivatives: index futures o cash market securities w/ no tracking attempt o commodity-like derivatives plus market-neutral long-short o tracking portfolio w/ over- or under-weighting o derivatives plus cash positions o currency risk management: active or passive hedging; can be joint decision w/ asset allocation, or after-thefact Rebalancing: set thresholds for triggering rebalancing: say percentage-of-portfolio approach •

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Strategic Asset Allocation for Individual Investors: consider: taxes; labor income; correlation of financial asset returns and future labor income; outliving resources T   I   j  HumanCapit  al  t  = ( ) Human capital: (  j =t )   j =t  (1 + r ) Asset Allocation and Human Capital:  investors w/ safe labor income will invest more in equities  investors w/ labor income highly positively correlated s/ stock markets should have less exposure to stocks  ability to adjust labor supply tends to increase investor’s optimal allocation to equities o establish risk and return characteristics of individual’s human capital •

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Mortality risk: life insurance and maybe liquidity reserve Longevity risk: should be directly related to asset allocation; consider allocating for higher long-term returns life annuity (fixed or variable; equity-indexed annuity) o

Strategic Asset Allocation for Institutional Investors: Defined-Benefit Plans: strong focus on ALM 1. regulatory constraints: min, max and “basket clause” (say limit on alternative asset holdings) o 2. liquidity constraints o consider acceptable levels of: risk of funding shortfalls; anticipated volatility of surplus; anticipated o volatility of contributions consider whether liabilities nominally fixed (inflation) o Foundations and Endowments: need high long-term rate low-cost-, easy-to-monitor, passive investment strategies o may have limited resources to fund costs and complexities of due diligence o Insurance Companies: mix of assets to 1. counterbalance risks inherent in mix of insurance products; 2. achieve stated return objectives taxable o contractual liabilities to insureds o usually ALM including yield, duration, convexity, key rate sensitivity, value at risk and effects of asset o risk on capital reqs Portfolio Segmentation: subportfolios for product lines o credit quality regulatory reqs o casualty insurers tend to have higher liquidity reqs o Banks: taxable w/ short- and intermediate-term liabilities ALM approach o  loan portfolio not liquid, so securities portfolio offsets  regulatory reqs on holdings •

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Tactical Asset Allocation: deliberately underweighting or overweighting asset classes relative to target weights can use derivative securities over asset classes: overlay strategy  based on principles: 1. market prices tell explicitly what returns are available o 2. Relative expected returns reflect relative risk perceptions o 3. Markets are rational and mean reverting o  but consider: changes in assets’ underlying un derlying risk attributes o changes in central bank policy o changes in expected inflation o o  position in business cycle • •

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Reading 27: The Case for International Diversification Traditional case: risk reduction (from low correlation) and superior expected returns Portfolio variance of return: σ p2 = w12 σ12 + w22 σ22 + 2w1w2ρ1,2σ1σ2; Portfolio standard deviation of return: σ p = w12 σ12 + w22 σ22 + 2w1w2ρ1,2σ1σ2 currency: return in $: r $ = r + s + (r x s); r is return in local currency and s is exchange rate movement; cross  product usually ignored •

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var(r $) = var(r+s) = var(r) + var(s) + 2cov(r,s) = σ f 2 = σ2 + σs2 + 2ρσσs; (ignoring cross product); σf 2 is the variance of foreign asset in $; σ2 is variance in local currency; σs2 is variance of exchange rate; and ρ is correlation of local currency asset return and exchange rate movement o contribution of currency risk is the difference between the combined standard deviation and the local currency equity return standard deviation. historical correlation experience: equity: generally low correlations across equity markets with or without currency hedging o o  bonds: low correlations when unhedged; regional blocs exist; hedged different b/c existence of  “leaning against the wind” policies of raising interest rates to defend currencies leads and lags: some lagged correlation c orrelation but can be explained by differences in time zones and not by b y some international market inefficiency that is exploitable, and drastically reduced correlations for longer p eriods Returns: int’l investing increases Sharpe ratios (both numerator and denominator effects) consider active vs. passive; costs and benefits of both o Optimization must be based on forward-looking / expected returns: real growth; economic flexibility; o forecasts may already be reflected in asset prices Currency risk: less than local equity risk but more than local b ond risk  o market and currency risks are not additive o currency risk can be hedged o should be measured for whole portfolio rather than individual markets; offsets o contribution of currency risk decreases as time period increases (PPP and mean reversion)

Low correlations: factors causing equity market correlations across countries to be relatively low are independence of  different nations’ economies and gov’t policies, technological specialization, independent fiscal and monetary  policies, and cultural and sociological differences for bonds: differences in national monetary and budgetary policies •

Case against int’l diversification: increase in correlations: correlations have trended upward capital market deregulation leads to more integration o capital mobility has increased o free trade opening has created more economic synchronization o o global corporations Correlation increases when markets are volatile: deviations from normality: fat tails (leptokurtic) o market volatility varies over time, but is contagious o correlation across markets increases dramatically during periods of high volatility (“correlation o  breakdown”)  positive surprises create returns and can’t always be surprised; one country doesn’t always outperform Barriers to int’l investments: familiarity w/ foreign markets: prefer to invest in local corps w/ int’l exposure o o  political risk: unstable and crises (which, in the face of, may have driven past high returns) o market efficiency:  liquidity: thin volume; capital controls;  lack of timely and reliable info   price manipulation and insider trading o Regulations: on max amts of investment; o Transaction costs: brokerage commission; stamp tax; custody costs; money-manager management fees higher for int’l investments; market impact of large purchases in the ADR market o Taxes: withholding; •

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Currency risk: (can be hedged)

Correlation during volatile periods: may estimate correlation in periods of high volatility of returns: “conditioning correlation on high volatility” (but is biased sampling) conclusion that correlation increases in periods of crisis seems to be simply a statistical bias due to faulty econometrics still some evidence of increased correlation in volatile periods •

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Global rather than int’l investing: global industry factors: increasing importance of industry factors; regional and country factors country factors still significant • • •

Case for Emerging Markets: large returns over long run  positive but moderate correlation w/ developed markets volatility: much larger; higher probability of shocks; lack of infrastructure; corruption correlation: int’l corr tends to increase in periods of crisis; crises may spread depending on whether factors creating the boom or crisis are primarily local or global currency risk: in crisis both stocks and currencies drop (compared to common situation of negatively correlated stocks and currencies) investability: max foreign ownership reqs o small free float o constrained repatriation of income and capital o discriminatory taxes o foreign currency restrictions o may be limited to authorized investors o market price impact o • • • •

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Reading 28: Fixed-Income Portfolio Management—Part 1 See chart p. 7 in book 4. Fixed-Income investment management process: 1. setting setting investment investment objectives objectives (and constraint constraints) s) 2. develop developing ing and impleme implementi nting ng portfol portfolio io strateg strategy y 3. moni monito tori ring ng port portfo foli lio o 4. adju adjust stin ing g portf portfol olio io Classification strategies: 1. Pure bond indexing indexing (or fully fully replication replication approach): approach): perfectl perfectly y match benchmark benchmark (costly to implemen implement) t) 2. Enhanced Enhanced indexing indexing by matchi matching ng primary primary risk factors: factors: a. primary primary matched matched factors: factors: say level level of interest interest rates, rates, yield yield curve twists, twists, changes in in spreads over  over  treasuries  b. by not not fully fully repl replica icatin ting, g, reduce reducess costs costs c. can can try try to enhan enhance ce retu return rn 3. Enhanced Enhanced Indexing by small small risk factor factor mismatches: mismatches: increase increase return return by tilting tilting toward sector, sector, quality, quality, term structure, etc.; intended to enhance return only slightly to cover admin 40963581.doc 53 of 114

4. Active Active management management by larger risk factor factor mismatches mismatches:: active management; management; deliberate deliberately ly larger mismatc mismatches hes 5. Full-blown Full-blown active active management: management: aggressi aggressive ve mismatches mismatches on duration, duration, sector sector weights weights and other  other  Indexing:  benchmark: generally: market risk: have comparable market risk (maturity and duration) o income risk: comparable assured income streams o credit risk: comparable, diversified and satisfying IPS o liability framework risk: some relation to duration of liabilities if play a role o risk profiles: yield curve changes (shift (90%), twist, other) o  matching techniques: cell matching (or stratified sampling): divide benchmark into representative cells and then match multifactor model: use set of factors that drive bond returns: effective duration; convexity adjustment; o key rate duration and PV distribution of CFs: o  key rate duration  divide into nonoverlapping periods and match PVs o Sector and quality percent o sector duration contribution: quality spread duration contribution o sector/coupon/maturity cell weights o issuer exposure (event risk) o Tracking risk: variability w/ which portfolio’s return tracks benchmark index return: standard deviation of active return; active return = portfolio’s return – benchmark  index’s return. tracking risk results from mismatches from: 1. portfolio duration, 2. key rate o duration and PV distribution of CFs; 3. sector and quality percent; 4. sector  duration contribution; 5. quality spread duration contribution; (and other factors listed under multifactor model technique) Enhanced Indexing Strategies: lower cost enhancements: control costs (say competitive bidding) o issue selection enhancements: conduct own credit analysis o yield curve positioning: overweighting undervalued areas of curve and o underweighting overvalued areas Sector and quality positioning: o  say tilt toward short-duration corporates   periodic over- or underweighting of sectors Call exposure positioning: determine probability of call around crossover point o •

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Active Strategies: accept large tracking risk:  process: 1. Identify which index mismatches are to be exploited o 2. Extrapolate market’s expectations (or inputs) from market data o 3. Independently forecast necessary inputs and compare w/ market’s expectations o 4. Estimate relative values of securities in order to identify areas of under- or overvaluation o Total Return Analysis and Scenario Analysis: total return analysis: assessing expected effect of trade on portfolio’s total return given interest rate o forecast •

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 TotalFutur  eDollars  n    Semiannual total return =     −1   Full  Pr  iceofBond    scenario analysis: conduct analysis on varied assumptions

Monitor/Adjust Portfolio and Performance Managing Funds Against Liabilities: Dedication Strategies: Immunization: portfolio over specified horizon that will earn predetermined return regardless of  o interest rate changes Cash Flow Matching: provides future funding of liability stream from coupon and matured principal o  payments of portfolio Immunization: rate changes offset by effect of reinvestment o Classical Single-Period Immunization: assured return (insulation from effects of interest rate changes) for specific time horizon;  set portfolio’s duration to duration of specified time horizon  set initial PV equal to PV of future liability  Rebalancing an Immunized Portfolio: as interest rates actually change, must rebalance; frequency based on cost/benefit  Determining Target Return: total return as opposed to yield to maturity; alternative would be zero-coupon bond w/ same duration and quality as portfolio  Time Horizon: immunized time horizon equal to portfolio duration  Dollar Duration: dollar duration = duration x portfolio value x 0.01; rebalancing for dollar  duration: 1. move forward in time w/ shift in yield curve; calculate new dollar duration 2. calculate rebalancing ratio: original dollar duration / new dollar duration – 1; result is % each position needs to change to be rebalanced 3. multiply new market value by %: amt of cash needed for rebalancing  Spread Duration: measure of how market value of bond portfolio changes when parallel 100  bps change in spread over benchmark  nominal spread: spread of bond over yield of certain Treasury static spread (or zero-volatility spread): constant spread over Treasury spot curve that equates calculated security price to market price option-adjusted spread (OAS): current spread over benchmark yield minus spread from embedded option extensions of classical immunization: o  multiple liability immunization: strategy that guarantees meeting specified schedule of future liabilities regardless of type of interest rate shift  contingent immunization: degree of active strategy will ensuring certain minimum return in case of parallel rate shift; immunization serves as fall-back strategy if actively managed  portfolio does not grow at certain rate cushion spread: difference b/w minimum acceptable return an d higher possible immunized rate  Duration and convexity of assets and liabilities: if liabilities and assets are duration matched but not convexity matched, economic surplus will be exposed to variation in value va lue from interest rate changes reflecting convexity mismatch  Types of Risk: interest rate risk  contingent claims risk: (say prepayment risk) •

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cap risk: say caps on floating rates  Risk Minimization for Immunized Portfolios: barbell portfolio is high risk while bullet  portfolio is low risk   portfolio w/ least reinvestment risk has least immunization risk  if manager can construct portfolio that replicates pure discount instrument that matures at investment horizon: immunization risk will be zero maturity variance: how much given immunized portfolio differs from ideal immunized  portfolio consisting of single pure discount instrument w/ maturity equal to time horizon use linear programming confidence intervals Multiple Liability Immunization:  for parallel rate shift, conditions: 1. duration of portfolio equals duration of liabilities; 2. distribution of durations of individual portfolio assets must have wider range than distribution of liabilities; 3. PV of assets must equal PV of liabilities Immunization for General Cash Flows: model cash contributions as p art of the portfolio along w/ their  durations Return Maximization for Immunized Portfolios: the greater the cushion spread, the more scope the manager has for active management policy •

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Cash Flow Matching: select securities to match timing and amount of liabilities compared to immunization: no reinvestment risk  o cash flow matching requires conservative rates of return o cash flow matching requires cash to be on or before liability date o generally inferior to immunization o extensions of basic CF matching: symmetric cash flow matching: short-term borrowing funds to satisfy liability prior to liability due date o (and matched CF maturity) combination matching (or horizon matching): creates portfolio that is duration-matched w/ added o constraint that it be cash-flow matched in first few years Application considerations: universe considerations: quality and characteristics of securities allowed to use o optimization o monitoring: periodic performance measurement o transaction costs o •

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Reading 29: Relative-Value Methodologies for Global Credit Bond Portfolio Management Credit Relative-Value Analysis Relative value: ranking of fixed-income investments by sectors, structures, issuers, and issues in terms of their  expected performance during some future period pe riod of time classic analysis: top-down and bottom-up analysis Relative-Value Methodologies: Total return analysis o o  primary market analysis liquidity and trading analysis o secondary trading rationales and constraints analysis o spread analysis o structure analysis o •

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credit curve analysis credit analysis o asset allocation / sector analysis o Total Return Analysis: optimize risk-adjusted total return; analyze detailed dissection of past returns and  project expected returns; uncover patterns (large v. small issue performance variation, seasonality, electioncycle effects, gov’t benchmark auction effects, etc.) Primary Market Analysis: new issue supply & demand; contrary to normal supply-price relationship, relative credit returns often perform best during periods of heavy supply effect of market-structure dynamics: adapt portfolio to long-term structure changes in composition of  o global credit asset class due to desire of issuers to minimize funding costs under different yield curve and yield spread, as well as needs need s of both active and asset/liability bond managers to satisfy their risk  and return objectives o Effect of product structure:  1. dominancy of bullet structures translates into scarcity value for structures w/ embedded call and put features  2. bonds w/ maturities beyond 20 yrs are small share of outstanding credit debt  3. use of credit derivatives has skyrocketed Liquidity and Trading Analysis: maybe trade potential liquidity disadvantage for incremental yields Secondary Trade Rationales: o  popular reasons for trading:  1. yield/Spread Pickup Trades: say determine rating differential b/w two issues irrelevant and  pickup yield difference  2. Credit-Upside Trades: when manager expects upgrade to issuer’s credit quality but not already reflected in yield spread; popular in crossover sector  geopo litical and economic uncertainties  3. Credit-Defense Trades: in defense of geopolitical n ew issuer or a new structure  4. New Issue Swaps: use swaps to add exposure to a new  5. Sector-Rotation Trades:  6. Curve-Adjustment Trades: portfolio duration tilt based on projected ch anges in credit term structure or credit curve  7. Structure Trades: swaps into structures expected to have better performance given expected expe cted movements in volatility and shape of yield curve ad vantage of cash flow reinvestment effect on spreads  8. Cash Flow Reinvestment: take advantage o Trading constraints:  1. Portfolio constraints: say from IPS or regulatory; say can’t own non-investment grade  2. “Story” Disagreement: action may be limited by uncertainty of one story over another   3. Buy-and-Hold: as a result of accounting constraints  4. Seasonality: say when month ends, or o r at year-end, when reports etc. made o

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Spread Analysis: Alternative Spread Measures: o OAS has diminished from reduction in structures w/ embedded option o zero-volatility spread o swap spreads in Europe credit spread using U.S. agency benchmark curve o credit-default swap spreads o Closer look at swap spreads: many practitioners envision convergence to single global spread standard derived from swap spreads Spread tools: 1. mean-reversion analysis o •

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2. Quality-Spread Analysis: examine spread differentials b/w low- and high-quality credits 3. Percent Yield Spread Analysis: An alysis: ratio of credit yields to gov’t yields for similar duration securities; not very predictive

Structural Analysis: bullet, callable, putable, sinking fund  bullets front-end bullets (1 to 5-yr maturities): useful for barbellers; asset swappers may co nvert short bullets o into floating-rate products intermediate credit bullets (5- to 12 yr maturities): o 30-yr maturity o Callables Sinking Funds: series of partial calls prior to maturity Putables: •

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Credit Curve Analysis: almost always positively sloped credit barbell strategy: take credit risk in short and intermediate maturities and substitute less-risky gov’t securities in long-duration portfolio buckets default risk increases non-linearly as credit-worthiness declines • •

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Credit Analysis: predict upgrades and downgrades Asset Allocation/Sector Rotation: “macro” among industrials, utilities, financial institutions, sovereigns, a nd supranationals “micro” detailed risk/return breakdown of main credit sub-sectors (banks, brokerage, energy, electrics, media, railroads, sovereigns, supranationals, technology); exhibit on book 4, p. 85 • •

Reading 30: Fixed-Income Portfolio Management—Part II Other Fixed-Income Strategies: Combination Strategies: active/passive combination; active/immunization combination Leverage: 1. the larger the amt of borrowed funds, the greater the variation in potential outcomes; 2. the greater the variability in annual return on invested funds, the greater the variation in potential outcomes o  portfolio rate of return =  R  P  = r   F  + ( B  E ) × ( r   F  − k )  D  A − D L L duration:  D E  =  A o  E  o Repurchase Agreements: K involving sale of securities such as Treasury instruments coupled w/ agmt to repurchase same securities on later date (functions like collateralized loan)  difference b/w selling price and purchase price referred to as “interest”   provides low-cost way for managers to borrow funds by providing Treasury securities as collateral  enables investors to earn return above risk-free rate on Treasury securities w/o sacrificing liquidity  transfer of securities: forms:  physical delivery (costly) transferred simply be credits and debits at clearing agent (still involves fees and charges) deliver securities to custodial account at seller’s bank (reduces costs) may not require delivery at all if comfortable • •

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Factors affecting repo rate: Quality of collateral Term of repo Delivery requirement: the greater the repo investor control, the lower the rate Availability of collateral: the more difficult (in short supply) it is to obtain the securities the lower the rate Prevailing interest rates in economy: if federal funds rate (unsecured overnight loans of  excess reserves) higher, higher rate seasonal factors Derivatives-Enabled Strategies: means to create, reduce or magnify factor exposures of an investment Interest rate risk: o • • • •

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 D ×V  ∑  portfolio duration is weighted avg: i

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adjustments to portfolio often such to keep duration d uration same, so often reference to dollar duration: Dollar duration =

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Other risk measures:  Semivariance: measures dispersion of return outcomes below target returns  Shortfall risk: probability of not achieving some specified return target  Value at risk (VAR): estimate of loss portfolio manager expects to be exceeded w/ given level of probability over specified time Bond Variance v. Bond Duration: standard deviation difficult to use to measure risk: number of  o  parameters to estimate increases dramatically w/ number of bonds; variances and covariances change w/ time Interest Rate Futures: o  cheapest-to-deliver; delivery options: quality option; timing option; wild card option  Strategies w/ Interest Rate Futures: price negatively correlated w/ interest rates: increases duration/sensitivity to interest rates Duration Management: use to match portfolio duration when deviates from target o  portfolio’s target dollar duration = Current portfolio’s dollar duration w/o futures + dollar duration of futures Ks Dollar duration of futures = dollar duration per futures K x number of futures Ks o Approximate # of Ks = o ( DT  −  D I  ) P  I  ( DT  −  D I  ) P   DCTD P CTD ( DT  −  D I  ) P  = × = × ConvFactor  ForCTDBond   DollarDurP erFuturesK   DCTD P CTD  DollarDurP erFuturesK   DCTD P CTD o

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Duration Hedging: futures Ks involves taking futures position that offsets existing interest rate exposure; if properly constructed as cash and futures prices move together  any loss realized by hedger from one position will be offset by profit in other  o  basis risk: risk that basis (difference b/w cash price and futures price) will change in unpredictable way o cross hedging: bond to be hedged is not identical to underlying u nderlying in futures; may involve substantial basis risk  o  price risk: risk that cash market price will move adversely; reason for hedging hedge ratio = factor exposure of bond (portfolio) to be hedged / factor exposure o of hedging instrument = (factor exposure of bond to be hedged / factor exposure

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of CTD bond) x (factor exposure of CTD bond / Factor exposure exp osure of futures K) =  D H  P  H   HedgeRatio = × ConvFactor  ForCTDBond   DCTD CTD P  CTD CTD Yield on bond to be hedged = a + b(Yield on CTD bond) + error term   b is beta yield  D H  P  H  × ConvFactor  ForCTDBond  × YieldBeta  HedgeRatio =  DCTD P CTD

Interest Rate Swaps: Dollar duration of interest rate swap: o  for pay float receive fixed: dollar duration of swap = dollar duration of  fixed-rate bond – dollar duration of floating rate bond Interest Rate Options: duration for option = delta of option op tion x duration of underlying x (price of  o underlying / price of option instrument) o  protective put establishes minimum value for portfolio covered call yields best results if prices are essentially going nowhere o o  buy calls to protect against decline in reinvestment rates also caps, floors and collars o Credit Risk Instruments: o credit risk: default risk, credit spread risk, downgrade risk  o credit options: protect against credit risk;  1. credit options written on underlying asset:  binary credit options provide payoffs contingent on occurrence of  specified negative credit events credit put option pays difference b/w strike price and o market price when event triggered  2. Credit Spread Options: payoff based on spread over benchmark: Payoff = Max [(Spread at option maturity – K) K ) x Notional amt x risk factor, 0] o credit forwards:  for buyer of credit forward: payoff = (Credit spread at forward K  maturity – Ked credit spread) x Notional amt x risk factor  credit swaps: credit default swaps, asset swaps, total return swaps, credit-linked o notes, synthetic collateralized bond obligations, basket default swaps  cds: for periodic premiums, agree to deliver physically ph ysically or cash upon default event •

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International Bond Investing: Active v. Passive Management; active: econo mic factors for selecting national markets o  bond market selection: analyze global economic o currency selection: o duration management / yield curve management o sector selection o credit analysis of issuers o investing in markets outside benchmark  Change in value of foreign bond = - Duration x Change in foreign yield given change in domestic yield x 100  y  foreign = α + β ∆y domestic ; beta is country beta ∆ o •

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Currency risk: 1. expected effect captured by forward discount/premium; 2. unexpected movement of foreign currency relative to forward rate interest rate parity: forward foreign exchange rate discount/premium over fixed period should equal o risk-free interest rate differential b/w two countries over period:   f   ≈ id  − i  f   hedging currency risk: forward hedging, proxy hedging, cross hedging o bo nd’s currency and home currency  forward hedging: use forward K b/w bond’s   proxy hedging: use forward K b/w home currency and currency highly correlated w/ bond’s currency;  cross hedging: using two non-home currencies to convert to a less-risky exposure to investor   for hedged position while IRP holds, hedged bond return:  HR ≈ r l  +   f   ≈ r l  + id  − i  f   = id  + r l  − i  f   ; sum of domestic risk-free interest rate plus bond’s local risk premium Breakeven Spread Analysis: determine the size of spread widening that would offset any yield advantage o

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spread widening that would eliminate yield advantage: W  =

YieldAdvan tage  Duration

; use the higher of the

two countries’ durations Emerging Market Debt: Growth and Maturity of the Market: after 1980s Mexican crisis, Brady plan allowed emerging country o gov’ts to securitize their date: Brady bonds; has resulted in liquid market for Brady bonds o Risk and Return Characteristics: potential for consistent attractive rates of return; countries can cut spending and raise taxes and borrow from IMF and World Bank; have currency reserves; but volatile; negative skewness; lack transparency: unclear laws and regs; little standardization in covenants and lacks enforceable seniority structure Analysis of Emerging Market Debt: look at: o mone tary policies; current debt levels, willingness  fundamentals: source of revenues, fiscal and monetary of citizens to make sacrifices  risk of being able to exchange currency   political risk and currency risk   changes in liquidity and taxation

Selecting a Fixed-Income Manager: Historical Performance as predictor of future performance: not necessarily good approach Developing Criteria for Selection: 1. Style analysis: helps explain historical performance o 2. Selection bets: decompose portfolio returns to determine manager’s selection skill o 3. organization’s investment process: research methods; decision process for changes o 4. Correlation of alphas: prefer low correlations across managers o Comparison w/ selection of equity managers: 1. both usually involve using consultants o 2. in both, past performance not reliable guide o 3. same qualitative factors: philosophy of manager and org, market opportunity, competitive o advantages, delegation of responsibility, experience of prof’ls 4. avoid high mgmt fees o • •

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Reading 31: Hedging Mortgage Securities to Capture Relative Value Convexity Value of mortgage security = value of Treasury security – value of prepayment option •

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many investors consider mortgages to be market-directional investments that should be avoided when interest rates expected to decline

Mortgage Security Risks: 1. Spread risk: o  portfolio manager does not seek to hedge spread risk, but increases allocation to mortgage securities when yield spreads are wide and reduces when narrow 2. Interest Rate Risk: corresponds to interest rate risk of comparable Treasury securities; can b e hedged directly by selling Treasury notes or Treasury note futures yield curve risk: exposure to nonparallel change in yield curve shape o  rate duration: can provide some measure of exposure  key rate duration: rate duration for key maturities can model steepening POs have high positive duration; IOs have high negative duration 3. Prepayment Risk: o w/ prepayment option, duration of mortgage securities extends a s rates rise and shortens as rates fall  the percentage increase in price becomes smaller and smaller as rates decline; percentage decline in price becomes greater and greater as interest rates rise. hedge by hedging dynamically or buying options o 4. Volatility Risk: option value increases w/ interest rate volatility hedge by hedging dynamically (when high volatility expected to normalize) or buying options (when o low volatility and expect to increase) 5. Model Risk: current models calibrate to historical experience; co nsider prepayment innovation cannot hedge, but can measure o •

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How Interest Rates Change Over Time: statistical technique used to decompose rate movements: principal components analysis 95% of historical movements in rate changes explained by 1. overall level of interest rates and 2. twists in yield curve • •

Hedging Methodology: Interest Rate Sensitivity Measure: Richard and Gord’s Interest Sensitivity (IRS): measures % price change in response to shift in yield curve o two bond hedge (say 2-yr and 10-yr Treasuries) o calculate appropriate two-bond hedge for typical yield curve shifts and twists o for shift: 1. compute prices for assumed interest rate increases and decreases (say 24.3 basis points as the typical monthly change in level) for each ea ch of (i) the mortgage security (ii) the 2-yr, and (iii) the 10yr  for shift: 2. determine 6 changes (yields) in step 1. o for shift: 3. calculate averages from increase and decrease (absolute values) for each of 3 in step 2. o for twist: 4. compute prices for assuming flattening and steepening (say 13.8 basis points as the typical o monthly twist) for each of 3 for twist: 5. determine 6 changes (yields) in step 4 o for twist: 6. calculate averages from flattening and steepening (absolute values) for each of 3 in step 5 o for shift: 7. compute change in value of 2-bond hedge for level change in yield curve o  H2 x (2-H priceL) + H10 x (10-H priceL) o for twist: 8. compute change in value of 2-bond hedge for twist  H2 x (2-H priceT) + H10 x (10-H priceT) •

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9. determine system of equations that equates change in value of 2-bond hedge to change in price of  mortgage security  H2 x (2-H priceL) + H10 x (10-H priceL) = -MBS priceL  H2 x (2-H priceT) + H10 x (10-H priceT) -MBS priceT 10. solve simultaneous equations for H2 and H10 o  properly hedged mortgage securities are not “market-directional” underlying assumptions of 2-bond hedge: 1. yield curve shifts are reasonable; 2. prepayment model estimates changing cash flows well; 3. underlying assumptions in Monte Carlo simulation hold; 4. avg price change ch ange is good approximation of price change for small interest rate movements o

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Hedging Cuspy-Coupon Mortgage Securities: where small changes in interest rates have large effect on prepayments and thus prices so, tangent line at yield is not a good proxy for price/yield changes more negative convexity than current coupon mortgages hedge by buying interest rate option • • •

Reading 32: Equity Portfolio Management Role of the Equity Portfolio o inflation hedge: if returns are sufficient on average to preserve purchasing power during periods of  inflation  superior protection for unanticipated inflation than nominal bon ds long-term portfolio growth o •

Approaches to Equity Investment:  passive, active, semiactive: Semiactive (aka enhanced indexing and risk-controlled active management): tracking risk watched o Information ratio = mean active return / tracking risk  o •

Passive Equity Investing: Equity Indices: Index Weighting Choices: o p rice; performance represented by one share (as  Price Weighting: according to absolute share price; adjusted for splits) of each index component; biased toward highest priced share  Value weighted (or market-capitalization weighted): weighted according to market cap;  performance represents owning all outstanding shares of index components; biased toward highest market cap float-weighted index: not all, but all of the free float (principal S&P funds are float weighted)  Equal weighted: say $1000 in each index component; require periodic rebalancing; small company bias o Composition and Characteristics of Major Indices:  most major are float-weighted  DJIA is price weighted Passive Investment Vehicles: o Indexed portfolios: 1. conventional index mutual funds; 2. ETFs; 3. separate or pooled accounts  separate or pooled accounts are extremely low-cost products (may be able to cover costs by security lending)  4 differences b/w ETFs and mutual funds: 1. shareholder accounting at mutual fund level and expensive; none for ETFs •

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2. ETFs pay higher index license fees 3. ETFs more tax efficient: in kind redemptions 4. ETFs pay transaction costs to trade but better protected w/ liquidity  full replication: say if fewer than 1000 stocks: costs that cause differences from index: cost of managing and administering fund transaction costs of adjustments to reflect changes in index composition transaction costs of investing and disinvesting cash flows drag from cash positions while market is upward trending  stratified sampling (aka representative sampling): 1. divide index along multiple dimensions (create multidimensional cells); 2. determine weight of each cell; 3. take random sample from w/i cells and weight according to cell weight; consider diversification reqs;  optimization: use multifactor risk model of index and individual securities, and function to minimize tracking risk; factors may be market cap, beta, industry, macro etc. accounts for covariances (stratified sampling does not) model risk  overfitting data requires periodic trading Equity Index Futures: use stock index futures; delivery involves portfolio trades / p rogram trades /  basket trades  consider uptick rules Equity Total Return Swaps:  application has been curtailed by U.S. tax law changes (constructive sales?)  tax-oriented applications focus primarily on differences in tax treatment accorded domestic and int’l recipients of corporate dividends (withholding taxes)  may save costs in case of rebalancing portfolio (tactical allocation) • • •

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Active Equity Investing: Equity Styles: value: focus on purchasing at low P/E o  say b/c of mean reversion  may be cheap for good economic reasons  low P/E style: usually found in defensive, cyclical and simply out of favor   contrarian style: look for stocks that have been beset by problems (P/B < 1); in depressed industries; buy when expected rebound  high yield style: purchase w/ high and growing dividend yield o growth: focus on selecting high-earnings-growth cos  industries include: technology, health care, consumer p roducts  consistent growth style: long history of unit-sales growth, superior profitability and predictable earnings relative strength indicators: compare stock’s performance during specific period to past  performance or performance of group  earnings momentum style: bet on continual high earnings growth o Other active management styles:  market oriented (aka blend or core): intermediate grouping; buy stocks based on intrinsic value regardless of whether value or growth; tends to resemble broad-market equity index w/ value bias: almost value style w/ growth bias: almost growth style •

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growth-at-a-reasonable price: above avg growth prospects selling at co nservative valuations (not as diversified as straight growth style) style rotators: invest in style that will be favored in the near term small cap style / micro cap style (underresearched, or better growth p rospects) mid cap (underresearched but stronger than micro caps) large cap: emphasis on superior analysis and insight Technique for identifying investment styles:  returns-based style analysis on portfolio returns (RBSA): regress realized returns on return series for set of securities indices (set must be mutually exclusive, exhaustive and risk distinct);  betas set to total 1. the weights set the “normal portfolio/benchmark” 1 minus style fit equals selection error term represents selection return  holdings-based style analysis (aka composition-based style analysis): categorize individual securities by characteristics and aggregate results; evaluate: valuation levels forecast EPS growth rate earnings variability: (greater would be indicative of value-oriented) industry sector weightings: value-oriented would have financing and utilities; growth have info tech and health care Barra fundamental multifactor risk model: commercial holdings-based style analysis model consider category approach (stick security in basket representing one style); quantity approach: divide security among baskets based on spectrum •

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2 approaches to style analysis: advantages and disadvantages Advantages Returns-based Characterizes entire portfolio style analysis Facilitates comparisons of portfolios Aggregates effect of investment process Different models usually give broadly similar results and portfolio characterizations Clear theoretical basis for portfolio categorization ca tegorization Requires minimal info Can be executed quickly Cost effective Holdings-based Characterizes each position style analysis Facilitates comparisons of individual positions In looking at present, may capture changes in style more quickly than returns-based analysis an alysis

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Disadvantages May be ineffective in characterizing current style Error in specifying indices in model may lead to inaccurate conclusions

Does not reflect way many portfolio managers approach security selection Requires specification of classification attributes for style; different specifications may give different results

Equity Style Indices:   buffering: rules for maintaining style assignment of stock consistent w/ previous assignment when stock has not clearly moved to new style  style index publishers use growth and value either as categories (no overlap) or as quantities qu antities (w/ overlap) Style Box: cross tabs by market cap and style based on holdings-based style analysis; Morningstar’s style box: 40963581.doc 65 of 114

Value # stocks # stocks # stocks

Large-cap Mid-cap Small cap

Core # stocks # stocks # stocks

Growth # stocks # stocks # stocks

Style Drift: inconsistency in style Socially Responsible Investing: positive and negative screens by: industry classification (avoid tobacco, gaming, alcohol, armaments, etc) o corporate practices (re: environmental pollution, human rights, labor standards, animal welfare, o integrity in corp governance, etc.) o may bias the style: say shift toward small-cap shares Long-Short Investing:  common constraint on shorting  two alphas: from long position and from short position  market neutral: zero beta, resulting in “portable alpha”   pairs trades Price Inefficiency on Short Side: impediments to short selling; opportunities arising from management o fraud, “window-dressing”, negligence; analysts always make many more buy recommendations; Equitizing Market-Neutral Long-Short Portfolio: given equity market systematic exposure; by holding o  permanent stock index futures position equal to cash position from shorts  may be better to short ETFs than to continually roll short futures positions  market neutral should have no systematic risk, so risk-free rate is benchmark; if equitized, then equity benchmark  Long-Only Constraint: underweighting is similar to shorting, but limited on extent of underweighting o (e.g., can’t short); asymmetric o Short Extension Strategies (aka partial long-short strategies): specifies use of stated level of short selling; say 130/30 Sell Disciplines/Trading: o  opportunity cost sell discipline: find stocks w/ higher risk-adjusted expected return and replace lower   deteriorating fundamentals sell discipline: sell when fundamentals deteriorating  rule driven: say P/E reaches historical avg: valuation-level sell discipline; also down-from-cost, up-from-cost, target price sell disciplines o

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Semiactive Equity Investing (aka enhanced index or risk-controlled active): perform better than benchmark w/o much additional risk  derivatives-based semiactive equity strategies: exposure to equity market w/ derivatives and enhance w/ other  than equity (say equitize cash and enhance enh ance by altering duration)  based on stock selection: generate alpha by selecting stocks  IR ≈ IC   IC  Breadth : info ratio approximately Grinold and Kahn’s Fundamental Law of Active Management:  IR equal to what you know about given investment (info coefficient) multiplied by square root of investment discipline’s breadth (number of independent active investment decisions made each year) •

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Managing a Portfolio of Managers: U  A = r  A − λ  Aσ  A2 •

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r  Ai  Ai : weighted avg of active return of managers

i =1

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uncorrelated Core-Satellite: to anchor a strategy w/ index or enhanced enh anced index and use active managers opportunistically around anchor to achieve acceptable level of active return while mitigating some active risk associated w/  portfolio consisting entirely of active managers core should resemble benchmark  o further breakdown of active return: o  manager’s return – manager’s normal benchmark = manager’s true active return  manager’s normal benchmark – investor’s benchmark = manager’s misfit active return o manager’s total active risk = [(Manager’s “true” active risk)2 + (Manager’s “misfit” active risk) 2]1/2 o manager’s risk-adjusted performance = IR = (Manager’s “true” active return) / (Manager’s “misfit” active risk) Completeness Fund: when added to active managers’ positions, establishes overall portfolio w/ approximately same risk exposures as investor’s overall equity benchmark  can be passive or semiactive o needs to be re-estimated periodically o misfit may be optimal while completeness fund tends to eliminate misfit o Other Approaches: Alpha and Beta Separation o say index for beta exposure, then hire managers for portable alpha

Identifying, Selecting and Contracting w/ Equity Portfolio Managers: Developing a Universe of Suitable Manager Manag er Candidates: consultants evaluate managers qualitatively (people and org structure, investment philosophy, decision-making process, strength of equity research) and quantitatively (comparisons w/ benchmarks and peers, measures style orientation and valuation characteristics) Predictive Power of Past Performance: good investment record of set of managers over long period following consistent disciplines, more likely to indicate future satisfactory results than comparable record for manager  w/ turnover and shifts in investment orientation Fee Structures: o ad valorem fees: multiply % by assets managed (management fee or AUM fees) o  performance-based fees: usually base fee plus sharing %;  may have fee cap  may have high water mark   one sided performance fee can be valued as an option Equity Manager Questionnaire: 5 areas: o 1. organization/people o 2. philosophy/process o 3. resources o 4. performance o 5. fees •

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Structuring Equity Research and Security Selection: Top-Down v. Bottom-Up: most investors use some combination Buy-Side v. Sell-Side: Industry Classification: S&P and MSCI: Global Industry Classification Standards (GICS): divided into: o • • •

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Reading 33: Corporate Governance Separation of Ownership and Control: corporate governance: “ways in which suppliers of finance to corps assure themselves of getting return on investment” consider stakeholders o Moral Hazard: insufficient effort: allocation of work time to various tasks o extravagant investments o entrenchment strategies: invest in lines of activities that make managers indispensible; manipulate o  performance measures; excessive or insufficient risk taking; resist hostile takeovers; lobby for limits on shareholder control and set up complex cross-holding structures o self-dealing: perks; pick a friend as successor; select costly supplier based on friendship; finance their   political picks; below-market-price asset sales w/ related party; insider trading Dysfunctional corporate governance: lack of transparency: levels of comp; stock options; perks; o comp level: “runaway compensation” o tenuous link b/w performance and comp: comp stable or increased despite poor performance; see o upside of market rises, but not downside of market falls; “getting out on time”: say selling options  before problems surface; golden parachutes o accounting manipulations: off-balance-sheet deals; hide poor performance; prevent violation of bank  covenants; continued financing •

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Managerial Incentives: Sophisticated Mix of Incentives: bonuses and stock options; concern about future; threat of being fired; financial distress; monitoring by large investors (also intrinsic motivation; fairness, horizontal equity, morale, trust, corp culture, social responsibility and altruism, feelings of self-esteem, interest in job; though economists concerned about residual incentives to act in firm’s interest over and beyond absence of rewards and monitoring) monetary incentives: o  comp package: salary, bonus and stock-based incentives   bonuses and shareholdings: substitutes or complements  comp base  straight shares or stock options:  exec comp controversy o implicit incentives: keep job; avoid proxy fight; avoid bankruptcy or reorg; o monitoring: by Boards, auditors, large shareholders, large creditors, investment banks, rating age ncies  active monitoring: interfering to increase investors’ claims; exercise of control rights  speculative monitoring: adjust position in firm: invest further, hold, sell (the analyst) o  product market competition: beneficial effects; may also create gambling b ehavior  •

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Board of Directors: watchdogs or lapdogs: lack of independence: may be hand picked by CEO; may have business relationships; bribes: lucrative o consultancy etc; mutual interdependence of CEOs o insufficient attention: unprepared and rely on management info o insufficient incentives: mostly just fees and perks; huge barriers to liability avoidance of conflict: ongoing relationship o Reforming the Board: o teammates or referees o knowledge versus independence: those closest to firm have knowledge but susceptible to conflicts of  interest o Link from performance to board comp:  Cadbury report calls for: 1. nomination of recognized senior outside member where chairman of the Board is CEO; 2. procedure p rocedure for directors to take independent professional advice at company’s expense; 3. majority of independent directors; 4. comp committee dominated by nonexecutives directors and audit committee conferred to nonexecutive directors most whom should be independent; also recommends against performance-based comp •

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CalPERS criteria Has outside chairman Only one insider on Board Some form of mandatory retirement for directors Independent nominating committee Fewer than 10% of directors over 70 Independent governance committee No retired CEO on the Board Independent ethics committee Independent audit committee A majority of outside directors on Board Independent comp committee

% companies in compliance 5% 18% 18% 38% 68% 68% 82% 85% 86% 90% 91%

Investor Activism: Active monitoring requires control: formal control: majority of voting shares etc. o real control: sufficient ownership to build coalition o  proxy fight Pattern of ownership: o  pension funds play minor role in France, Germany, Italy and Japan; ownership concentration in such countries is substantial; also cross-shareholdings ownership concentration: high in Italy, France, Germany, Sweden, S weden, Europe generally, East Asia o  extremely dispersed in U.S. dispersed in Anglo-Saxon countries stability of holdings v. active management: Japan and German stable; Anglo-Saxon reshuffle o frequently Limits of Active Monitoring: who monitors the monitor: monitors not always acting in interest of their beneficiaries o o congruence w/ other investors:  undermonitoring: substantial free-riding by small institutional shareholders  collusion w/ management: quid pro quo  self-dealing: transactions w/ affiliated firms •

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Cost of providing proper incentives to monitor: entails liquidity costs to cause long-term holding which allows for proper monitoring Perverse effects on the monitorees: become short-term focused Legal, fiscal, and regulatory obstacles: liability for directors; holding restrictions once reach ownership threshold; diversification rule;

Takeovers and Leveraged Buyouts: keep managers on their toes, but may cause myopia allow for fresh ideas from new managerial teams raider may be value-reducing may shatter implicit Ks w/ stakeholders Takeover Bids and Defenses: usually preceded by toehold o tender offer  o defenses: o  corporate charter defenses: staggered board supermajority rule fair price clauses  placing shares in ESOP differential voting rights dual-class recapitalizations move to state w/ tougher antitakeover statutes  dilution defenses: Scorched-earth policies litigation  poison pills   post-takeover bid defenses: white knights greenmail Leveraged Buyouts: o  buyout partnership arrangement: 1. strong monetary incentives of new managers of that of publicly traded corp; 2. active monitoring taken seriously; 3. high leverage o Rise and backlash:  Hypothesis 1: Decline of corp governance  Hypothesis 2: Financial innovation: new and superior form of corporate governance  Hypothesis 3: Break-up of conglomerates  verdict: large gain for target shareholders neutral outcome for acquirer  increase in total value • • • • •

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Debt as a Governance Mechanism: as incentive mechanism: forces firm to disgorge cash flow managers can’t consume cash o o managers must focus on repaying creditors o threat of financial distress o residual claim goes to entrepreneur so right incentives •

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costs of illiquidity; say to fund projects; say in face of uncontrollable adverse shocks  bankruptcy costs:  direct costs  indirect costs: managerial decisions in anticipation transaction costs: lots of parties to deal w/  bargaining inefficiencies:

International Comparisons of the Policy Environment:  protection of shareholders is strongest in common law countries, weakest in French-style civil law countries and somewhere in b/w in German- and an d Scandinavian-style law  positive covariation b/w shareholder protection and breadth of equity market substitute protections: mandatory dividends o more concentrated ownership structures o •

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Shareholder Value or Stakeholder Society? list of stakeholders: duties toward employees o duties toward communities o duties toward creditors o ethical considerations: environment, pay taxes, avoid bribes o rather than simply make longer-term investments, stakeholder perspective is at extreme of “socially responsible corporation is one that consciously makes decisions that reduce overall profits.” arguments against: discourages financing in first place o o inefficiencies in decisionmaking: conflicting objectives resulting in deadlocks o difficulty in accountability created by such wide array of immeasurable missions o tax on business whose proceeds escape control by political process shareholder value position: freedom of contract: •

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stakeholder society: Incentives and Control Issues: o monetary incentives:  explicit: bonuses and stock options: measure on aggregate welfare; but recommendation that stakeholder value would be best promoted by fixed wage enlarged fiduciary duty  implicit: substitute for explicit incentives in environments in which performance cannot be well-described ex ante, but can be better assessed after the fact due to accrual of new info career concerns analogy to joint ventures: heterogeneity of interests among partners of joint venture seriously impedes efficacy: conflicts of interest among partners create mistrust and lead to deadlocks to decision making •

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Cadbury Report: Code of Best Practice: 1. Board of Directors o 2. Non-Executive Directors o 3. Executive Directors o o 4. Reporting and Controls o  Notes and add’l recommendations •

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Reading 34: International Equity Benchmarks:  Need for Float Adjustment: consider cross-holdings; no int’l equity benchmark uses full cap any more Trade-Offs in Constructing Int’l Indexes: Breadth v. investability: consider illiquidity of smallest-cap in emerging markets o Liquidity and crossing opportunities v. index reconstitution effects: most popular and widely used o indexes and benchmarks have greater index level liquidity for investors seeking to buy or sell index fund position or actively managed position resembling index  also program/portfolio trades: crossing, but with a broker   reconstitution effects: upward price pressure on stocks chosen for inclusion in index and vice versa Precise float adjustment v. transaction costs from rebalancing: no longer matter of controversy: all o indexes have some float adjustment  float bands allow for less transaction costs Objectivity and transparency v. judgment: o Emerging market benchmark: MSCI EMF for emerging markets (similar to MSCI EAFE for developed markets) some transaction costs and reconstitution effects in index changes • •

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Reading 35: Emerging Markets Finance Market integration and liberalization: financial liberalization: allowing inward and outward foreign equity investment market prices can change upon upo n announcement of liberalization or as soon as investors anticipate liberalization may occur in the future expected returns should decrease as volatility decreases; but may become more sensitive to world events (increasing covariance w/ developed markets) Barriers to integration: legal barriers treating foreign and domestic investors differently o indirect barriers from differences in available info, accounting standards and investor protection o emerging market risks: liquidity, political risk, economic policy risk, currency risk  o • •

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Financial Effects of Market Integration: Liberalization and returns: o dividend yields decline after liberalization but by less than 1% on average o  possibility that pre-liberalization returns already biased from integration o unconditional correlations and betas increase after liberalization liberalization and capital flows: net capital flows to emerging markets increase rapidly after liberalization, but level out after 3 yrs o concern that portfolio flows are not as “sticky” as fdi o liberalization and political risk: some evidence country ratings significantly increase (lower risk) w/ equity market liberalization o liberalization and diversification benefits: small but significant increase in conditional correlations and reduced diversification benefits •

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after gov’ts follow policies inconsistent w/ peg? as self-fulfilling: investors just decide to speculate against and cause crisis? o if self-fulfilling, then channel for contagion income effect channel: reduced growth and lower income levels after crisis reduce demand for imports from other countries “wake up call” channel: second country also experienced similar negative macroeconomic conditions or  followed similar inconsistent policies other channels: credit crunch; forced-portfolio recomposition or liquidity effect o

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Other issues: Corporate finance: emerging markets as testing ground for legal institutions / agency theories Fixed Income: high correlation b/w emerging market debt and equity returns Market Microstructure: price discovery; liquidity Stock Selection: information asymmetry; returns not explained by traditional asset pricing models Privatization: transfer of productive resources from public sector to private sector  • • • • •

Reading 36: Alternative Investments Portfolio Management Diligence on Alternative Investments: 1. mark market et oppo opport rtun unit ity y 2. inve invest stme ment nt proc proces esss 3. orga organi niza zati tion on 4. people 5. term termss and and stru struct ctur uree 6. serv servic icee prov provid ider erss 7. documents 8. write-up Also: • • • • •

tax issues determining suitability communication w/ client decision risk  concentrated equity position of client in closely held company

Real Estate: types: •

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direct: residences, commercial real estate, agricultural land indirect:  homebuilders, real estate operating companies, etc.  REITs Equity REITs own and manger office buildings, apartment buildings, shopping centers, etc. Mortgage REITs invest >75% of assets in mortgages; lend money to builders and make loan collections Hybrid REITs: operate real estate and buy mortgages  Commingled real estate funds (CREFs ) Opened ended and closed ended (closed are usually leveraged) Private investment vehicles •

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Separately managed accounts  Infrastructure funds: Designs, finances, and builds projects Financed by debt and equity Leased to public sector to operate; allows public sector to avoid raising debt Benchmarks and historical performance: o Direct real estate: in U.S.: National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index;  Value weighted  Includes subindices for apartments, industrial, office and retail and by geographic region  Based on property appraisals; underestimate volatility   Not an investable index Indirect real estate investment: o   NAREIT Real time market-cap weighted index of all REITs actively traded on NYSE and Amex Also monthly equity REIT index Also other specialized subindexes  Note that the underlying REITs often leveraged Real Estate: Investment Characteristics and Roles: Has intrinsic value o Substantial income component o Lack of liquidity o Large lot sizes o o High transaction costs o Heterogeneity o Immobility o Low info transparency Factors: interest rates (real interest rates); term structure of interest rates; change in GDP; growth in o consumption; population growth; unexpected inflation o Inflation hedge? o Idiosyncratic variables o Benefits:  Deductible mortgage interest  Permits more financial leverage  Direct control over property  Can obtain diversification through different geographic locations  Low volatility compared to public equities Disadvantages: o   Not easy to divide parcels; only large part of portfolio  High cost of info  High broker commissions  Substantial operating and maintenance costs  Risk of neighborhood deterioration  Political risk on tax deductions Follows economic cycles o Provides some diversification benefits relative to stock/bond portfolio, but relatively less effective than o hedge funds and commodities  But unsmoothed NCREIF provided greater diversification benefits • • •

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o

Apartments have highest risk-adjusted returns; office have lowest

Private Equity / Venture Capital: Private equity funds: financing private businesses, leveraged buyouts of public companies; distressed debt investing; public financing of public infrastructure projects Buyout funds: mega-cap buy-out funds: take public companies private; middle-market buy-out funds: o  purchase private companies whose revenues and profits are too small to access capital from public equity markets managem ent  Add value by: restructuring operations and improving management Opportunistically purchasing at discount Gains from adding debt or debt restructuring  Insert management  Dividend recapitalization  Capital commitments come from: public pension funds, corporate DB pension plans, endowments, foundations, family offices  Types: •

• •

Investment Processes of (Direct) Private Equity Investment and Investment in Publicly Traded Equities Private Equity Investments Publicly Traded Securities Structure and Valuation Deal structure and price are negotiated b/w the Price is set set in context of market. Deal structure investor and company management is standardized. standardized. Variations typically typically required required approval from securities regulators. Access to Info for Investment Selection Investor can request access to all info, Analysts can use only publicly available info to including internal projections assess investment potential Post-Investment Activity Investors typically remain heavily involved in Investors typically do not sit on corporate the company after the transaction by Boards or make ongoing assessments based on  participating at the Board level and through  publicly available info and have limited access regular contact w/ management to management. •

Venture capital: equity financing of new or growing private companies Assist in IPO o May use PPM o Demand for VC: o  Formative-stage companies: newly formed to product development stage  Expansion-stage: expanding sales stage, significant revenues, stage of preparing for IPO  Financing stages: Early-stage financing: Seed o Start-up o First-stage o Later-stage financing: The Exit: o  Merger   Acquisition  IPO •

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Supply of VC:  Angel investors  VC  Large companies: corporate venturing / strategic partners o Convertible preferred stock  PE and VC usually indirect investment vehicles: limited partnerships o Management fee plus incentive fee (carried interest)  Carried interest sometimes subject to hurdle rate and subject to claw back  Funds of funds: o Benchmarks: annualized IRRs compiled by Cambridge Associates, Thomson Venture Economics, and NVCA. Performance of fund based on manager’s appraisals o Make vintage year comparisons o PE: Investment Characteristics and Roles: o Growth o Investment characteristics:  Illiquidity  Long-term commitments required  Higher risk than seasoned public equity investment  High expected IRR required  (for VC) limited info Differences b/w PE and VC: o  Buyout funds are usually highly leveraged  CFs to buyout fund investors come earlier and are often steadier than VC  Returns to VC fund investors subject to greater error in measurement Roles: o  PE has moderately high correlation w/ public equity  More idiosyncratic risk   Ability to achieve sufficient diversification (high commitments)  Liquidity of position  Provision for capital commitment  Appropriate diversification strategy Other issues: Evaluation of prospects for market success o  Markets, competition and sales prospects  Management experience and capabilities  Management’s commitment (consider % ownership and comp incentives)  Cash invested (by management)  Opinion of customers  Identity of current investors Operational review o  Expert validation of technology  Employment contracts  Intellectual property Financial/legal review o  Potential for dilution of interest  Examination of financial statements o

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Commodity Investments: 40963581.doc 76 of 114

•

Types: Direct commodity investment: cash market purchase involving actual possession and storage Indirect commodity investment: say as equity in companies specializing in production o Benchmarks: Reuters Jefferies/Commodity Research Bureau (RJ/CRB) Index – uses unequal fixed weights based on o  perceived relative importance Goldman Sachs Commodity Index (GSCI) – arithmetic averaging of monthly component returns; total o return version and spot version o Dow Jones-AIG Commodity Index (DJ-AIGCI) o S&P Commodity Index (S&PCI) Historical performance: On stand-alone basis, commodities have lower Sharpe ratio than U.S. and world bonds and equities o Correlations w/ traditional asset classes are close to zero o o Return components: spot return / price return; collateral return; roll return (positive for long in  backwardation market) Investment characteristics: Understand investment characteristics of commodities on sector- or individual-commodity level o Special risk characteristics: o  Unusually low correlations w/ equities and bonds  Price risk in periods of financial and economic distress  Long-term growth in world demand in limited supply: long-term trend growth  Generally business cycle sensitive  Determinants of return: 1. business cycle-related supply and demand: 2. convenience yield: embedded consumption timing option; inverse relationship b/w level of inventories and convenience yield Samuelson effect: term structure of forward price volatility generally declines w/ o time to expiration (mismatched supply and demand at shorter horizons, but equilibrium in longer horizons) 3. Real options under uncertainty:  Inflation: “natural” sources of return; protection against unexpected inflation Positive correlation w/ unexpected inflation Roles: o Potent risk diversifier  o Inflation hedge: classes such as livestock and agriculture exhibit negative correlation w/ unexpected inflation as measured by monthly changes in inflation rate; storable commodities directly linked to economic activity exhibit positive correlation w/ changes in inflation and have superior inflationhedging properties o

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Hedge Funds: Types: •

o o o o o o o

Equity market neutral: roughly equal exposure long and short Convertible arbitrage: Fixed-income arbitrage: mispricing based on term structure of interest rates or credit q uality Distressed securities: Merger arbitrage: Hedged equity: not equity market neutral Global macro: 40963581.doc 77 of 114

Emerging markets: Fund of funds o Groups: Relative value o Event driven o o Equity hedge o Global asset allocators o Short selling Fees: o AUM fee and incentive fee o High-water mark  Initial Lock-up period: maybe 1 to 3 yrs Benchmarks: CISDM of the University Un iversity of Massachusetts o Credit/Suisse/Tremont o EACM Advisors o Hedge Fund Intelligence Ltd. o HedgeFund.net o HFR  o MSCI o Dow Jones Hedge Fund Strategy benchmarks o o HFR hedge fund indices o MSCI Hedge Invest Index o Standard & Poor’s Hedge Fund Indices Differences in major manager-based hedge fund indices: Selection criteria: which hedge funds are included o Style classification: o Weighting scheme: o Rebalancing scheme: o o Investability: Absolute return vehicles? Defined as having no benchmark, while estimates of alpha must be b e made relative to a benchmark  Can establish comparable portfolios using 1. single factor or multifactor methodology; 2. optimization o to create tracking portfolios w/ similar risk and return characteristics Historical performance: HFCI has higher Sharpe ratio than any other reported assets; correlation of 0.59 w/ S&P 500 o o  b/c equity hedge funds load on similar return factors as S&P 500, offer less diversification than many relative-value strategies and can be more rightly considered return enhancers Interpretation Issues: Biases in Index Creation: concern is whether index reflects actual relative sensitivity of hedge funds to o various market conditions, such that each index provides info on true diversification benefits of  underlying hedge fund strategies Relevance of Past Data on Performance: best forecast of future returns is one that is con sistent w/ prior  o volatility and not one that is consistent w/ prior returns Survivorship Bias o Stale price bias: results in lower reported correlations o o

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Backfill bias (inclusion bias): when missing past return date for component of index are filled at discretion of component when it joins the index—only components w/ good past results will be motivated to supply them Investment Characteristics: o Common set of return drivers based on trading strategy factors (e.g., option-like payoffs) and location factors (e.g., payoffs from buy-and-hold policy) help explain returns of each strategy Long-biased hedge funds are return enhancers rather than diversifiers o o Hedge funds attempting to be least affected by market direction may be diversifiers Role in portfolio: Scrutinize managers o Emphasize style selection o o Often have option characteristics that present challenge when relying on MVO o Mean-variance improvement o Lower skewness and higher kurtosis  Adopt mean-variance, skewness and kurtosis-aware approach to hedge fund selection  Invest in managed futures: tends to have skewness opposite many hedge funds Other issues: o Young funds outperform old funds on a total-return basis, or at least old funds do not n ot outperform young ones On average, large funds underperform small funds o FOFs may provide closer approximation to return estimation than indices do o o Performance fees and lock-up periods: some evidence ev idence of better performance of funds w/ quarterly lock-ups over monthly FOFs: style drift: may time one market and have become b ecome less useful in asset allocation strategies o FOFs: don’t usually impose lock-up periods o Fund size: smaller more nimble and higher risk-adjusted returns; larger have more clout o Age (vintage) effects o Hedge Fund Due Diligence: Structure o Strategy o Performance data o o Risk  o Research o Administration o Legal References o Performance Evaluation: Returns: monthly usually; o  Rate of return = [(Ending value of portfolio) – (Beginning value of portfolio)]/(Beginning value of portfolio)  Usually compounding over 12 mos; frequency can materially affect reported performance b/c entry and exit and drawdowns  Typically “look through” leverage as if asset were fully paid  Rolling return: moving average of holding-period returns that matches investor’s time horizon:  RR12,t  = ( Rt  + Rt −1 + Rt −2 + ... ... + Rt −12 ) / 12  RRn,t  = ( Rt  +  Rt −1 +  Rt −2 + ... +  Rt −n ) / n ;  RR o Volatility and Downside Volatility:  Annualize monthly by multiplying by 12  Positive excess kurtosis and skewness o

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n

min n ( r  − r  ,0) ] ∑ [mi *



o

Downside deviation =

i =1

2

t 

n −1  Maximum drawdown: largest difference b/w high-water point and subsequent low  Length of drawdown period: time from high-water mark until next high-water mark  Performance Appraisal Measures:  Sharpe ratio; limitations: Time dependent and increases proportionally p roportionally w/ square root of time Doesn’t account for asymmetrical return distribution or negative or positive skewness Illiquid holdings bias upward Doesn’t account for serial correlation Doesn’t account for correlations w/ other investments  Not very good predictive ability for hedge funds Can be gamed: lengthening measurement interval; compounding monthly returns but calculating standard deviation from not compounded monthly returns Writing out of the money puts and calls on a portfolio Smoothing of returns w/ derivative structures Getting rid of extreme returns w/ total return swaps  Sortino ratio = (Annualized rate of return – annualized risk-free rate)/Downside deviation  Gain-to-loss ratio = (Number of months w/ positive returns / Number of months w/ negative returns) x (Average up-month return/ average down-month return)  Calmar ratio  Sterling ratio Correlations: assumes normality Skewness and Kurtosis: positive skewness is good; high kurtosis means extreme returns Consistency:   Number of positive months  % positive months  Avg return in up-months   Number of negative months  % negative months  Avg return in down-months  Avg monthly return in index up-months  Avg monthly return in index down-months • • • • • • •

• • •

o o o

Managed Futures: private pooled investment vehicles veh icles that can invest in cash, spot, spo t, and derivative markets for benefit of investors and have ability to use leverage; run by general partners known as commodity pool operators (CPOs) skill based, absolute-return strategies types: private commodity pools; separately managed accounts; publicly traded commodity funds o investment style: systematic (rule based or trend based) or discretionary (based on trader beliefs or  economic data) markets traded: currency, financial, or diversified (financial, currency and commodities) o o trading strategy (e.g., trend following or contrarian) Benchmarks: Mount Lucas Management Index: based on technical trading rules o CISDM CTA: based on peer group o Performance: • •

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standard deviations comparable to U.S. blue-chip stocks; Sharpe ratio better than equities but not bonds o correlations slightly negative w/ equities; 0.42 and 0.46 w/ U.S. and global bonds respectively o Interpretation: survivorship bias o Investment characteristics: potential for improved risk and return derivative markets are zero-sum games: passively managed, unlevered futures position should earn o risk-free return on invested capital less management fees and transaction costs momentum strategies and trend following; resulting in positive skewness o diversification capabilities (to stocks and bonds) o Roles: o diversification from stocks, bonds and hedge funds improved Sharpe ratios o other issues: o  performance persistence; o leveraged o

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Distressed Securities: securities of companies in financial distress or near bankruptcy or already in Chapter 1 1: many investors cannot hold b/c of IPS; unresearched: exploit the inefficiency skill in negotiation or influencing management Types: hedge fund structure: more liquid o o  private equity fund structure: closed end types of assets: o   publicly traded debt and equity securities in distressed company  newly issued equity of co emerging from reorg (orphan equity)   bank debt and trade claims  “lender of last resort” notes  variety of derivative instruments for hedging purposes Benchmarks: subindexes of major hedge fund indices: EACM, CISDM, HFR; Altman-NYU Salomon Center  o Defaulted Public Bond and Bank Loan Index Performance: non-normal: negative skewness (downside risk); large kurtosis (outlier events) o high mean returns w/ low standard deviation: high Sharpe ratio o low correlation w/ world stock and bond bon d investments o investment characteristics: o consider IPS restrictions (limits to investment grade; might be required to sell fallen angels) Roles: Long-Only Value Investing: investing in undervalued distressed securities; if public debt: high-yield o investing; if orphan equities: orphan equities investing Distressed Debt Arbitrage: purchasing co’s traded bonds and selling short its equity o Private Equity: become major creditor to influence o   prepackaged bankruptcy: converting distressed debt to private equity Risks: o  event risk   market liquidity risk   market risk  • • •

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J factor risk: judge’s track record in adjudicating bankruptcies ban kruptcies and restructuring not normal illiquid stale pricing

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other issues: Bankruptcy in U.S. v. other countries: o  other countries, bankruptcy usually liquidation; rehabilitation of debtor is distinctive to U.S. Absolute Priority Rule: satisfy senior claims first (but new value exception) o Prepackaged Bankruptcy Filing: debtor agrees in advance w/ creditors on plan of reorg b/f formally o files for Chap 11 protection

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Reading 37: Swaps Commodity swaps: fixed price of swap is weighted average of corresponding forward prices. n

∑ P ( 0, t  ) F   F  = ∑ P ( 0, t  ) i

0,t i

i =1

n

i

i =1

n

∑ Q  P ( 0, t  ) F  With varying quantities:  F  = ∑ Q  P ( 0, t  ) t i

i =1

0 ,t i

i

n

i =1

t i

i

For summer and winter varying:  F  s  P (0, t i )Qt  + F  w  P (0, t i )Qt  =

∑

i

i∈summer 

∑

i∈w int er 

i

∑ P (0, t  )Q  F 

i∈summer 

i

t i

0 ,ti

+

∑ P (0, t  )Q

i∈w int er 

i

t i

F 0,ti

Because fixed swap payment equal, while the futures prices vary, the mismatch creates a borrowing/lending component.

Reading 38: Commodity Forwards and Futures  F 0 ,T 

= S 0 e ( r −

δ  ) T 

Synthetic commodity: long forward plus zero coupon bond b ond w/ face value equal eq ual to forward price Link b/w expected commodity price and forward price:  F 0,T 

=  E 0 ( S T  ) e ( r −α )T 

 Nonstorability: Electricity: different prices in summer and winter and in night and day •

Commodity Lease Rate: •

• • • •

δ l 

= r  −

1 T 

ln( F 0,T  S )

Cash and carry arbitrage: borrow cash, buy commodity, lend commodity and short forward Reverse cash and carry arbitrage: short commodity, lend ca sh, long forward Contango occurs when lease rate is less than risk-free rate; Backwardation occurs when lease rate is greater g reater than risk-free rate 40963581.doc 82 of 114

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Carry: storage Forward price with storage costs (like negative dividend; app lies only when storage occurs):  F 0,T 

= S 0 e ( r +

λ ) T 

( r +λ −c )T 

Forward price factoring in convenience yield:  F 0,T  = S 0 e o Those who earn convenience yield likely already hold optimal amount of commodity; there may be no way for you to earn convenience yield when performing cash and carry ( r +λ −c )T  ≤  F 0,T  ≤ S 0 e ( r +λ )T  o For average investor arbitrageur, price range w/I w /I when no arbitrage is S 0 e

Gold Futures: Easily storable; often sold certificated; Has lease rate: use lease formula to determine lease rate; synthetic gold generally preferable way to obtain exposure •

Seasonality: Corn Forward Market: Harvested in U.S. from Sept to Nov. Prices rise at interest rate plus storage costs; falls at harvest Occasional storage across harvests • • •

 Natural Gas: Seasonality and storage costs Difficult to transport internationally so, forward curves vary regionally Costly to store In U.S., demand highest in winter months Steady stream of production w/ variable demand (as opposed to corn) • • • • •

Oil: • •

Easy to transport Easier to store than gas

Commodity spreads: some commodities are inputs in creation of other commodities Crush spread: position in soybeans and opposite position in equivalent quantities of soybean meal and soybean oil Crack spread: oil and distillates: oil => gas & heating oil •

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Hedging Strategies: Basis risk: the price of the commodity underlying the futures contract may move differently than price of  commodity you are hedging o Say based on differing delivery locations and times o Say differing grades Strip hedge: buy commodity over time for over-time obligation; stack hedge: enter futures w/ single maturity w/ number of Ks selected so that changes in PV of future obligations are offset by changes in value of “stack” of futures Ks. Stack and roll: stacking futures Ks in near-term K an d rolling over into new near-term K (profitable in  backwardation) Weather derivatives: (a cross hedge): contracts that make payments based upon realized characteristics of  weather  o Heating degree-day o Cooling degree-day •

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Reading 39: Risk Management: 40963581.doc 83 of 114

Risk Management Process: 1. Set Policies & Procedures 2. Define Risk Tolerance 3. Identify Risks 4. Measure Risks 5. Adjust Level of Risk  6. Execute Risk Management Transactions 7. Identify Appropriate Transactions 8. Price Transactions 9. Execute Transactions • • • • • • • • •

Risk Governance: Enterprise risk management (ERM): centralized risk management for overall company at level close to senior  management. Steps: 1. Identify each risk factor exposed to o 2. quantify each exposure’s size in money terms o 3. map inputs into risk estimation calculation o 4. identify overall risk exposures as well as contribution from each factor  o 5. set reporting process to senior mgmt: committee o 6. monitor compliance o •

Identifying Risks: market risk (interest rate risk, exchange rate risk, equity price risk, commodity price risk); credit risk; liquidity risk; operational risk; model risk; settlement risk; regulator risk; legal/contract risk; tax risk; accounting risk; sovereign/political risk  Market risk: interest rate risk, exchange rate risk, equity price risk, commodity price risk  Credit risk: counterparty risk  Liquidity risk: that financial instrument cannot be purchased or sold w/o significant concession in price Size of Bid-ask spread: a measure of o f liquidity risk  o Volume o Operational Risk: risk from failure in co’s systems and procedures or from external events Model Risk: Settlement (Herstatt) Risk: paying counterparty while counterparty is declaring bankruptcy May net to reduce o Regulatory Risk: how transactions will be regulated or that regulation will change Legal/Contract Risk: say fraud or illegal contract, or otherwise unenforceability of K  Tax Risk: uncertainty associated w/ tax laws Accounting Risk: uncertainty about how transaction should be recorded and potential for accounting rules and regulations to change Sovereign and Political Risks: changing political conditions in countries Sovereign risk: where borrower is gov’t o Political risk: changes in political environment o Other risks: ESG risk: environmental, social and governance o Performance netting risk: potential for loss resulting from failure of fees based on net performance to o fully cover contractual payout obligations to individual portfolio managers that h ave positive  performance when other portfolio managers have losses and when there are asymmetric incentive fee arrangements w/ the portfolio managers • • •

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o

Settlement netting risk: that liquidator of a counterparty in default cou ld challenge netting arrangement so that profitable transactions are realized for benefit of creditors

Measuring Risk  Measuring Market risk: standard deviation / volatility o active risk / tracking risk / tracking error volatility o o  beta, duration, delta o convexity, gamma o vega, theta Value at Risk (VAR): probability-based measure of loss potential, expressed as % or units of currency; “estimate of loss (in money terms) that we expect to be exceeded with a given level of probabiliby over a specified time period.” requires: 1. probability level; 2. time period; 3. model o analytical or variance-covariance method: infer VAR from standard deviation and normal distribution o  delta-normal method: assume that change in option price is assumed to equal change in underlying price multiplied by delta (avoids non normality of options) Historical Method (historical simulation method): set VAR according to actual historical experience / o historical distribution  nonparametric diversification effect: difference b/w sum of individual VARs (say for different divisions) and total o VAR  o Monte Carlo Simulation Method: o “Surplus at Risk”: VAR as it applies to pension funds o  backtesting: process of comparing number of violations v iolations of VAR thresholds w/ figure implied by userselected probability level Extensions and Supplements to VAR: Incremental VAR (IVAR): measures incremental effect of an asset on VAR  o cash flow at risk (CFAR) o earnings at risk (EAR) o tail value at risk (TVAR): VAR plus the expected loss in excess of VAR, when such excess loss occurs o Stress Testing: identify unusual circumstances that could lead to losses in excess o f typical Scenario analysis: under different states of the world o  actual extreme events  hypothetical events o Stressing Models: un derlying model in most disadvantageous way and  factor push: push prices and risk factors of underlying work out combined effect  maximum loss optimization: optimize mathematically the risk variable that will produce the max loss  worst-case scenario analysis Measuring Credit Risk: likelihood of loss and amount of associated loss o current credit risk (jump-to-default risk): risk of events happening in immediate future o credit VAR (default VAR or credit at risk) option-pricing theory and credit risk: bond w/ credit risk can be viewed as default-free bond plus o implicit short put option on the assets written by bondholders for stockholders o credit risk of forward Ks: current credit risk at expiration; otherwise, potential credit risk  o credit risk of swaps: credit risk present at series of points •

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for interest rate and equity swaps: potential credit risk is largest during middle period of swap’s life  currency swaps have greatest credit risk b/w midpoint and end of life o credit risk of options: unilateral credit risk  Liquidity Risk: maybe liquidity-adjust VAR estimates o Measuring Nonfinancial Risks: maybe more suitable for insurance (maybe extreme value theory) operational risk: o Basel II o

Managing Risk: key components: effective risk governance model, which places p laces overall responsibility at senior mgmt level, allocates o resources effectively and features appropriate separation of tasks b/w revenue generators and those on control side of business o appropriate systems and technology to combine info analysis in such way as to provide timely and accurate risk info to decision makers o sufficient and suitably trained personnel to evaluate risk info and articulate it to those who need info for purposes of decision making Managing Market Risk: Risk Budgeting: might be set in terms of VAR units or on individual transaction size, amount of  o f  o working capital needed to support suppo rt the portfolio or amount of losses acceptable for any given time  period, or IR for portfolio managers, or risk to the surplus. Also:   performance stopouts  working capital allocations  VAR limits  Scenario Analysis limits  risk factor limits   position concentration limits  leverage limits  liquidity limits Managing Credit Risk: one-sided risk  Reducing Credit Risk by Limiting Exposure: limit transactions w/ any single counterparty o o Reducing Credit Risk by Marking to Market: OTC derivatives (options not marked to market) o Reducing Credit Risk with Collateral: usually cash or highly liquid, low-risk securities o Reducing Credit Risk with Netting: used in two-way contracts (forwards, swaps); also netting among multiple contracts: closeout netting  cherry picking: bankrupt company enforcing only profitable contracts (not netting) Reducing Credit Risk w/ Minimum Credit Standards and Enhanced Derivative Product Companies: o  Enhanced Derivatives Products Companies (EDPCs): subsidiaries separated from parent’s debts so as to minimize counterparty risk  o Transferring Credit Risk with Credit Derivatives:  credit default swaps  total return swap  credit spread option  credit spread forward Performance Evaluation: Sharpe ratio o •

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Risk-Adjusted Return on Capital (RAROC): divides expected return by a measure of capital at risk  Return over Maximum Drawdown (RoMAD): average return in given year over maximum difference o  b/w high-water mark and subsequent low o Sortino Ratio: Sortino Ratio = (Mean portfolio return – minimum acceptable return (MAR))/Downside deviation (below MAR) Capital Allocation: measure of capital: 1. nominal, notional, or monetary position limits (seldom sufficient risk control) o 2. VAR-based position limits o 3. Maximum loss limits o 4. Internal capital requirements: say using VAR  o 5. Regulatory capital requirements o Psychological and Behavioral Considerations: risk governance should anticipate points in cycle when incentives of risk takers diverge from those of capital allocators (say when fall into negative performance) o

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Reading 40: Currency Risk Management Hedging w/ Futures or Forward Currency Ks: Basic Approach: Hedging Principal: unhedged asset return: V t * −V 0* o •

•

= V t S t  −V 0 S 0

o

return on hedge: Realized gain =V 0 ( − F t  + F 0 )

o

Profit = V t S t 

o

hedged position rate of return:  R H 

−V 0 S 0 + V 0 ( − F t  + F 0 )

=

V t S t  − V 0 S 0 V 0 S 0

+

( − F t  + F 0 ) S 0

=  R* − R F 

Minimum-Variance Hedge Ratio: used when foreign currency value of foreign investment reacts systematically to an exchange rate movement o  R H  =  R * − h × R F  o

*

optimal hedge ratio (regression hedge ratio): h =

cov( R * , R F  ) 2

; also can be estimated as R * = a + h*R F

σ   F 

•

+ error term Translation risk: from translation of value of asset from foreign currency to domestic currency; hedge o ratio for translation risk is 1   R H  − R =  s (1 − h ) : minimizing the first term comes from an h of 1 Economic Risk: when foreign currency value of foreign investment reacts systematically to an o exchange rate movement (say when country raises interest rates to fight currency depreciation) cov ( R, s )  hedge ratio estimated by: σ  s2 Hedging Total Currency Risk: both translation risk and econ omic risk  o Influence of the Basis: futures and spot exchange rates differ by a basis Basis risk: basis equals interest rate differential o Implementing hedging strategies: o  1. short-term Ks, rolled over at maturity  2. Ks w/ matching maturity  3. long-term Ks w/ maturity extending beyond hedging period Hedging Multiple Currencies: o  try to find Ks on other currencies that are closely correlated w/ (nonactively traded) investment currencies 40963581.doc 87 of 114

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optimization techniques can be used to construct hedge w/ futures Ks in only o nly a few currencies  practice: select independent major currencies w/ futures Ks available run multiple regression of domestic currency returns of portfolio on futures returns of  selected currencies use regression coefficients as hedge ratios • •

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Insuring and Hedging w/ Options: as insurance or as hedging by accounting for relationship b/w premium and underlying exchange rate Insuring w/ Options: V    P  otherwise. o  Net dollar profit on put = V 0 ( K  − S t  ) −V 0 P  0 when K>St; = •

−

0

0

 Not a good hedge unless variations in spot price swamp the premium Dynamic hedging w/ options: match dollar loss (gain) in u nderlying w/ dollar gain (loss) in option Good currency hedge requires holding –V0/δ options; hedge ratio is 1/δ; (delta hedge) o Hedge ratio fluctuates o Where direction of currency movement is clearly forecasted, currency futures provider cheaper hedge o o

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Other Methods for Managing Currency Exposure: Buying high beta equities Increase duration of foreign portfolio to foreign interest rates w/o increasing currency exposure w/ options, currency fluctuations affect mostly translation of profit into dollars not the principal (if the underlying were bought instead) see chart on p. 314 • • •

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Strategic and Tactical Currency Management: Strategic Hedge Ratio: see IPS for private investors and benchmark hedge ratio for institutional investors Traditional approach: minimize variance: fully hedge currency o Total Portfolio Risk: depends on proportion of int’l assets; may add some diversification o Asset Types: different currency sensitivities o Investment Horizon: longer the horizon, the lower the benchmark hedge ratio o Prior Beliefs on Currencies: may see weakness in own currency o Costs: transaction costs, administrative and monitoring; interest rate differential o Is Regret Proper Measure for Currency Risk? Hedge 50% to minimize regret? o Currency Overlay: manage currency risks in existing portfolio; not to speculate Given parameters on hedge ratios and max level of tracking error relative to benchmark; or set of  o acceptable currencies Tactical approaches: o  Management of the Currency Risk Profile: active risk management through dynamic hedging or option-based approaches: protect from downside and allow for upside potential  Technical Approach: exploit temporary market inefficiencies by identifying predictable price  patterns and volatility  Fundamental Approach: economic analysis Shouldn’t separate asset allocation from currency exposure: currency overlays are subop timal o Currencies as an Asset Class: Low correlation b/w currencies and equities; also low b/w currencies and bonds o Absolute return basis: currency for alpha funds o •

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Reading 41: Risk Management Applications of Forward and Futures Strategies 40963581.doc 88 of 114

Strategies and Applications for Managing Equity Market Risk: cov SI  Beta: β  = 2 •

σ  I 

o

o

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Dollar beta: beta times portfolio value; for futures, beta times futures price

 β T  − β S    S                 f   β      f        

 Number of futures contracts to obtain target beta:  N   f   = 

Creating equity out of cash: long stock = long risk-free bond + long futures o

Rounded off number of futures contracts to buy:  N   f  * =

V (1 + r ) qf  

T 

; resulting investment is no longer V

*

*

 but V*: V 

•

=

 N   f  qf  

(1 + r ) T 

; and dividends are treated as reinvested and result in larger number of contracts

than if just received the dividends, the implicit number of contracts starting with (growing to the *  N   f   q  previous number of contracts by the dividend reinvestment) is ; however transaction does not (1 + δ ) T  actually capture dividends, just the performance of the index Equitizing Cash: do above transaction; maintains liquidity of cash o Consider the under/over pricing of the futures o Creating Cash out of Equity: Long stock + short futures = Long risk-free bond Effectively convert (V/S)(1+δ)T to cash; o T  V (1 + r ) * o

o

 N   f  

V *

=−

=

qf  

− N  qf   (1 + r ) T  *   f  

Asset Allocation w/ Futures: If reducing equity position, use futures to reduce the beta of the dollar amount of such reduction to zero: say want to turn $10M of equity position to bonds, sell futures such that beta on $10M is zero; then buy bond futures. •

o

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For the bonds:  N bf  

    B =  MDUR T  − MDUR  B      f  b MDUR   f      

Pre-Investing in an Asset Class: don’t have the cash currently, but will in future; long underlying + loan = long futures; like a fully leveraged position in the underlying;

Strategies and Applications for Managing Foreign Currency Risk: Transaction exposure: risk of exchange rate movement on a somewhat predictable future cash flow in foreign currency (say a co’s foreign sales) Translation exposure: need to consolidate balance sheets of foreign subs Economic exposure: say reduced sales when currency appreciates Transaction exposure: Managing risk of foreign currency receipt: as if long the foreign currency; lock in exchange rate by o selling forward (short) o Managing risk of foreign currency payment: as if short the foreign currency; lock in exchange rate by  buying forward (long) Managing risk of foreign-market asset portfolio: future value of portfolio unknown; o •

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If only foreign stock market return hedged, portfolio return is foreign risk-free rate b/f  converting to domestic currency; if both foreign stock market and exchange rate risk are hedged, return equals domestic risk-free rate

Futures or Forwards? Risks that have specific dates: use forwards Forward market been around for longer than futures market and is liquid Dealers of forwards use futures to quickly hedge their own risk  Forwards allow to keep private transaction activity • • • •

Reading 42: Risk Management Applications of Option Strategies Risk Management Strategies w/ Options and the Underlying: Reduce exposure to underlying unde rlying by: 1. selling a call; or 2. buying a put. Covered call: underlying plus short call. max ( 0, S T  −  X  ) + c0 Profit: Π = S T  − S 0 − max o • •

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Protective put: underlying plus long put o Profit: Π = S T  − S 0 + max( 0,  X  − S T  ) − p0 Can be viewed as insurance o Money Spreads: (as compared to time spreads: which differ by expiration date) o Bull spreads: makes money if market rises: long position in call w/ exercise price and short position in o call w/ higher exercise price  Value at expiration: V T  = max( 0, S T  −  X 1 ) − max( 0, S T  − X 2 ) Profit: Π = max ( 0, S T  −  X 1 ) − max( 0, S T  −  X 2 ) − ( c1 − c 2 )  Maximum profit =  X 2 − X 1 − c1 + c2  Maximum loss = c1 −c 2 *  Breakeven price: S T  =  X 1 + c1 − c 2 Bear spreads: makes money if market goes down: sell call w/ exercise price and buy call ca ll w/ higher  exercise price; or: buy put w/ exercise price and sell put w/ lower exercise price  Value at expiration: V T  = max ( 0,  X 2 − S T  ) − max ( 0,  X 1 − S T  )  Profit: Π = max ( 0, X 2 − S T  ) − max ( 0, X 1 − S T  ) −  p 2 + p1 

o

Maximum profit =  X 2 −  X 1 −  p 2 + p1  Maximum loss =  p 2 − p1 *  Breakeven: S T  =  X 2 −  p 2 +  p1 Butterfly spreads: combines bull and bear spread: buy calls w/ exe rcise price X1 and X3 and sell two calls w/ exercise price X2 max ( 0, S T  −  X 1 ) − 2 max max ( 0, S T  −  X 2 ) + max max ( 0, S T  − X 3 )  Value at expiration: V T  = max max ( 0, S T  −  X 1 ) − 2 max max ( 0, S T  −  X 2 ) + max ( 0, S T  −  X 3 ) − c1 + 2c2 − c3  Profit: Π = max 

o

    

Maximum profit =  X 2 − X 1 − c1 + 2c2 − c3 Maximum loss = c1 − 2c2 + c3 * * Breakeven: S T  =  X 1 + c1 − 2c2 + c3 and S T  = 2 X 2 −  X 1 − c1 + 2c 2 − c3 Strategy based on expectation of low volatility in underlying; profitable if less volatility than market expects; if expect to be more volatile than market expects, sell the butterfly spread Can create w/ puts: buy puts w/ exercise prices X1 and X3 and sell two puts w/ exercise price X2. 40963581.doc 90 of 114

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Combinations of Calls and Puts: (aka range forward or risk reversals) Collars: underlying plus long put plus short call o  zero-cost collar: premium received for call offsets premium paid for put  Value at expiration: V T  = S T  + max( 0, X 1 − S T  ) − max( 0, X 2 − S T  ) max ( 0,  X 1 − S T  ) − max max ( 0,  X 2 − S T  ) − S 0 ; (assuming zero-cost collar) Profit: Π = S T  + max  maximum profit = X2 – S0  maximum loss = S0 – X1 *   breakeven: S T  = S 0 Straddle: buy call and put as same price; bet on large volatility  makes sense only when investor believes market will be more volatile than everyone else  value at expiration: V T  = max( 0, S T  −  X ) + max( 0, X  − S T  ) 

o

 

o o o

o

 profit:

Π = max( 0, S T  −  X ) + max( 0,  X  − S T  ) − c0 − p0

∞

maximum profit = ST – c0 – p0;  maximum loss = c0 + p0 *   breakeven ST = ST + c0 + p0 or ST – (c0 + p0) Strap: add call to straddle Strip: add put to straddle Strangle: straddle with different exercise prices; similar graph as straddle but w/ flat section in stead of   point on bottom Box Spreads: combination bear and bull spread: buy call w/ exercise price X1 and sell call w/ exercise  price X2 and buy put w/ exercise price X2 and sell put w/ exercise price X1.  value at expiration: ma x( 0,  X 1 − S T  ) ; thus: X2 – X1 V T  = max ( 0, S T  −  X 1 ) − max ( 0, S T  −  X 2 ) + max ( 0,  X 2 − S T  ) − max    

 profit: Π =  X 2 −  X 1 − ( c1 − c 2 +  p 2 − p1 ) maximum profit = (same as profit) maximum loss = (no loss possible, given fair option prices) Breakeven: no breakeven; transaction always earns risk-free rate, given fair option prices

Interest Rate Option Strategies: calls pay off if option expires w/ underlying interest rate above exercise rate (used by / benefits borrowers);  puts pay off if option expires w/ underlying interest rate below exercise rate (used by / benefits lenders).  payoff of interest rate call option: (notional principal) max(0,Underlying rate at expiration – Exercise rate) (Days in underlying underlying rate / 360). say borrow at LIBOR LIBOR and want cap on interest rate paid  payoff of interest rate put option: (notional principal) max(0,Exercise rate – Underlying rate at exp iration) (Days in underlying rate / 360). say lend at LIBOR and want floor on interest rate received Interest rate cap w/ floating-rate loan : Cap: series of interest rate call options w/ same exercise rate on individual caplets note that first payment is set at start so makes no sense to set cap on such known rate o Interest rate floor w/ floating-rate loan : floor: series of interest rate put options w/ same exercise rate on individual floorlets Interest rate collar w/ floating-rate loan : long cap plus short floor (to offset some or all of premium). (usually used by borrowers, but could be reversed for a lender) •

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Option Portfolio Risk Management Strategies: could lay off risk using put-call parity: c = p + S-X/(1+r)T; not commonly employed b/c of availability and  pricing could delta hedge: •

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delta = change in option price / change in underlying price  N c =− 1 o ∆c ∆S   N S  o  but gamma  gamma = change in delta / change in underlying price  as expiration approaches, deltas of in-the-money options will move toward 1.0 and deltas of  out-of-the money options will will move towards 0.0. So if close to expiration expiration and at-the-money, can have fast moves to 1.0 or to 0.0 delta constantly changing (price and time) o  further away the underlying price moves from current price, the worse the delta-based approximation and effects are asymmetric for calls, delta underestimates effects of increases in underlying and overestimates effects of decreases in underlying some error from rounding o delta is the N(d1) term in Black-Scholes o use continuously compounded rates o can delta hedge with a similar option rather than underlying: need delta b/w the options o any additional funds released from selling underlying or other options are invested in risk-free bonds o Vega and Volatility Risk: vega = change in option price / change in volatility option more sensitive to vega when at-the-money o  bullish equity investors buy calls; bullish bond investors buy puts o

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Reading 43: Risk Management Applications of Swap Strategies Using Interest Rates Swaps to Convert a floating-rate loan to a fixed-rate loan (and vice versa) (swaps are most common instrument used to manage interest rate risk) duration: pay-fixed is similar to long position in floating-rate bond and short position in fixed-rate bond. swaps function as hedge from planning and accounting perspective, but tremendously speculative from market value perspective • • •

Using Swaps to Adjust Duration of Fixed-Income Portfolio:  pay-fixed: duration of floating-rate bond minus duration of fixed-rate bond: value is negative •

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 MDURT  − MDUR B     ; NP is notional principal of swap; B is value of bond portfolio   MDUR S     

 NP  =  B

approximation of duration of swap: 75% of the maturity minus (1 divided by 2 times the frequency o f the floating payments); so for 4 year maturity w/ quarterly floating payments: .75 x 4 – 0.125 = 2.875.

Using Swaps to Create and Manage Risk of Structured Notes: Structured Notes: short- or intermediate-term floating-rate securities w/ feature: leverage, or inverse feature, etc. using swaps to create and manage risk of leveraged floating-rate notes (leveraged floating-rate note or  leveraged floater): issue structured note w/ say 1.5 times LIBOR interest payments; invest 1.5 times proceeds (not clear where extra .5 comes from) in fixed rate bonds; swap the fixed rate payment for LIBOR; swapped LIBOR payment is on a notional principal 1.5 times structured note so its payments equal the payment on the structured note. using swaps to create and manage risk of inverse floaters: issue structured note, invest proceeds in fixed-rate note, then swap fixed rate for floating rate to match structured note •

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Strategies and Applications for Managing Exchange Rate Risk: Converting a loan in one currency into a loan in another currency: say issue bond in home country in home currency, swap proceeds for foreign currency and receive o interest payments in home currency (to further pay bond payments p ayments in home country) while paying interest in foreign currency; (may have to come up with additional proceeds to cover the fixed  payments on the home country bond); bond ); at end of life, undo notional no tional amounts of swap. Converting Foreign Cash Receipts into Domestic Currency: no exchange of notional principals; say pay fixed amount in foreign currency and receive fixed amount in home currency Using Currency Swaps to Create and Manage Risk of Dual-Currency Bond: interest paid in one currency and  principal paid in another: say multinational generates sufficient cash in foreign currency to pay interest but not enough to pay principal; (equivalent to issuing ordinary bond in one currency and combining w/ currency swap that has no principal payments) •

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Strategies and Applications for Managing Equity Market Risk: (to continue managing equity market risk after expiration, swap would need to be renewed periodically and would be subject to new environment) Diversifying a Concentrated Portfolio: (say large equity gift that can’t sell) o  pay return on one equity and receive return on another equity; no exchange of principal o consider problem of negative return: could mean payment of both negative return normally to be received from other party and payment of positive return normally to be paid. Achieving International Diversification: swap such that give up domestic market performance for return on international market also consider possibility of negative cash flow o consider tracking error if keyed to indexes o Changing Asset Allocation b/w Stocks and Bonds: Bo nds: swap return on one class for return on another class o consider tracking error if keyed to indexes o consider cash flow problems Reducing Insider Exposure: same as diversifying concentrated portfolio o consider issues of insiders selling (b/c not avoided by swap) •

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Strategies and Applications Using Swaptions: options to enter into swaps  payer swaption: put equivalent on coupon bond; receiver swaption: call equivalent on coupon bond Using Interest Rate Swaption in Anticipation of Future Borrowing: Using Interest Rate Swaption to Terminate Swap: Synthetically Removing (Adding) a Call Feature in Callable (Noncallable) Debt: remove call by selling receiver swaption: equivalent to selling call on coupon bond; bond ; makes sense if  o rates not expected to fall: receive premium and if rates don’t fall swaption not exercised and an d not required to pay at the underlying fixed rate. o add call by buying receiver swaption: equivalent to buying call on coupon bond; makes sense if  interest rates expected to fall; pay premium, and then have ability to receive underlying fixed rate in case interest rates fall. (difference is that synthetically removing (adding) involves lump sum premium whereas with o embedded feature, premium is allocated over o ver time in the coupon payments) use payer swaptions if want to synthetically replicate put features on putable bonds. not common. o • • • • •

Reading 44: Execution of Portfolio Decisions Context of Trading: Market Microstructure: 40963581.doc 93 of 114

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Order Types: market order: instruction to execute order promptly in public markets at best price available o d egree of price uncertainty  emphasizes immediacy of execution; bears some degree limit order: trade at best price available but only if price is at least as good as specified limit price o  emphasizes price; has execution uncertainty o market-not-held order: where handled by broker; not-held means not required to trade at specific price or specific time interval; allows for discretion to not trade based on judgment o Participate (do not initiate) order: variant of market-not-held: broker stays deliberately low-key and waits and responds to initiatives of more active traders (to capture better price) Best efforts order: even more discretion to broker to judge market conditions o undisclosed limit order: doesn’t disclose total quantity of order  o Market on open order: to be executed at opening of market o market on close order: to be executed at market close o o (principal trade: broker buys/sells the position for self) o (portfolio trade (or program trade or basket trade): specified basket of securities; reduces risk to other  side of asymmetric info) Types of Markets: (markets provide liquidity, transparency and assurity of completion)  market fragmentation: many places to trade  straight through processing: automatic settlement of trade after execution  open outcry auction market: old style Quote-Driven (Dealer) Market: dealers establish firm prices at which securities can be bought and sold o  (closed-book markets: if limit order book is not visible in real time to public)   bond markets are overwhelmingly dealer markets (b/c of o f lack of liquidity)  effective spread: 2 x deviation of o f actual execution price from midpoint of market quote at time order is entered (may result in effective spread lower than quoted spread) Order-Driven Markets: transaction prices established by public limit orders o  Electronic Crossing Networks: buy and sell orders are batched (accumulated) and crossed at specific point in time, usually anonymous fashion (POSIT is an electronic crossing network) avoids dealer costs and effects a large order can have on price and information leakage volume may be low doesn’t provide price discovery (where transactions prices adjust to equilibrate supply and demand)  Auction Markets (periodic/batch auction markets or continuous au ction markets): orders of  multiple buyers compete for execution (after reopening market for day may be auction market)  Automated Auction (Electronic Limit-Order Markets): computer-based auctions that operate continuously w/i day using specified set of rules to execute orders Brokered Markets: transactions largely effected through search-brokerage mechanism away from o  public markets  mostly used for block transactions  also in less liquidity countries Hybrid markets: say NYSE: batch market at opening, con tinuous auction market (intraday trading) and o quote-driven market Roles of Brokers and Dealers represent the order  o find opposite side of trade o supplying market information o o  providing discretion and secrecy o  providing other supporting investment services • • •

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supporting market mechanism Evaluating Market Quality: liquidity: o  low bid-ask spreads  market is deep  market is resilient: only small discrepancies b/w market price and intrinsic value and corrected quickly  factors contributing to liquidity: many buyers and sellers diversity of opinion, info and investment needs convenience market integrity transparency: o   pretrade transparency: quickly, easily and inexpensively obtain accurate info about quotes and trades   post-trade transparency: details of completed trades are quickly and accurately reported to  public Assurity of the contract o o

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Costs of Trading: transaction cost components: o explicit costs: broker commissions, taxes, stamp duties and exchanges fees o implicit costs:   bid-ask spread  market impact  missed trade opportunity  delay costs (b/c of size of order and liquidity of market) (measures) o  time-of-trade midqoute  volume-weighted average price (VWAP): avg price security traded at during day weighted by trade volume  implementation shortfall: difference b/w money return on notional or paper portfolio in which  positions are established at prevailing price when decision to be made (decision price) and actual portfolio return explicit costs (commissions, taxes, fees) realized profit/loss: price movement from decision price (often using previous day’s close). though if broken over several days, each day has its own benchmark  Delay costs (slippage): close-to-close price movement over day order placed w hen order is not executed that day and an d based on amount of order actually subsequently filled; This is zero for any shares traded same day as decide to trade. missed trade opportunity cost (unrealized profit/loss): price difference b/w trade cancellation price and original benchmark price based on amount of order that was not filled  market adjusted implementation shortfall: difference b/w money return on notional or paper   portfolio and actual portfolio return, adjusted using beta to remove effect of return on market if 1% market move and beta be ta of 1.0, then subtract 1% from implementation shortfall; the 1% is not counted against you •

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Comparison of VWAP and Implementation Shortfall 40963581.doc 95 of 114

VWAP - easy to compute Advantages - easy to understand - can be computed quickly to assist traders during execution - works best for comparing smaller trades in nontrending market Disadvantages - does not account for costs of trades delayed or  cancelled - becomes misleading when trade is substantial  proportion of trading volume - not sensitive to trade size or market conditions - can be gamed by delaying trades •

Implementation Shortfall - links trading to portfolio manager activity; can relate cost to value of investment ideas - recognizes tradeoff b/w immediacy and price - allows attribution of costs - can be built into portfolio optimizers to reduce turnover and increase realized performance - requires extensive data collection and interpretation - imposes unfamiliar evaluation framework on traders

Pretrade analysis: Econometric Models for Costs: o factors: stock liquidity characteristics; risk; trade size relative to available liquidity; momentum; trading style

Types of Traders and Their Preferred Order Types: Types: o information-motivated traders: act quickly on info;  need liquidity and speed of execution over better price  likely use market orders and rely on market makers  use less obvious orders and may use dealers o value-motivated traders: based on slow research  wait for better price and accumulate over time  use limit orders liquidity-motivated traders: not based on info, but may simply need to release cash o  use market, market-not-held, best efforts, participate, principal trades, portfolio trades and orders on ECNs and crossing networks o  passive traders: work for index funds etc.  concerned about cost of trading: exchange lack of urgency for lower-cost execution  use limit orders, portfolio trades and crossing networks day traders: rapidly buy and sell o •

Trade Execution Decisions and Tactics: Decisions Related to Handling Trade: small, liquidity-oriented trades can be packaged up and executed via direct market access (DMA; o  platforms sponsored by brokers that permit buy-side traders to directly access equities, fixed income, futures, and foreign exchange markets, clearing via the brokers) large, info-laden trades: need skill o Objectives in Trading and Trading Tactics: Liquidity-at-Any-Cost Trading Focus: o  expensive but timely execution Costs-Are-Not-Important Trading Focus: market orders o o  Need-Trustworthy-Agent Trading Focus: for larger orders   best efforts, market-not-held or participate Advertise-to-Draw-Liquidity Trading Focus: IPOs, secondary offerings, sunshine trades o Low-Cost-Whatever-the-Liquidity Trading Focus: o •

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limit orders

Objectives in Trading Focus Uses Immediate execution Liquidity at any in institutional block  cost (I must trade) size

Costs High cost due to tipping supply/demand  balance Higher commission;  possible leakage of  info

Advantages Weaknesses Guar Guarant antee eess execu executi tion on High High pote potent ntia iall for  market impact and info leakage

Hopes to trade time for improvement in  price

Loses direct control of trade

Pays the spread; may create impact

Competitive, marketdetermined price

Cedes direct control of trade; may ignore tactics w/ potential for lower cost More difficult to administer; possible leakage to frontrunners Uncertainty of  trading; may fail to execute and create need to complete at later, less desirable  price

Need trustworthy agent (possible hazardous trading situation) Costs are not important

Large-scale trades; low-level advertising

Advertise to draw liquidity

Large trades w/ lower  High operational and Market-determined info advantage org costs  price for large trades

Low cost whatever the liquidity

 Non-info trading; indifferent to timing

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Certainty of  execution

Higher search and monitoring costs

Lower commission; opportunity to trade at favorable price

Automated Trading: o algorithmic trading: automated electronic trading subject to quantitative rules and user-specified  benchmarks and constraints smart routing: use algorithms to route orders to most liquid venues o classifications of algorithmic execution systems: o  Logical Participation Strategies: Simple Logical Participation Strategies: o  break up order over time according to prespecified volume profile: a VWAP strategy o or time-weighted average price (TWAP) strategy: assumes flat volume and trades in proportion to time or percentage-of-volume strategy o Implementation Shortfall Strategies: solves for optimal strategy to minimize trading costs as measured by implementation shortfall  Opportunistic Participation Strategies: post some orders at beneficial prices, use hidden orders and take advantage of crossing networks, seize liquidity when arises  Specialized Strategies:  passive order strategies: no guarantee of execution “hunter” strategies: seek liquidity market-on-close algorithms: target closing price smart routing •

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Serving the Client’s Interests: 40963581.doc 97 of 114

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CFA Institute Trade Management Guidelines: o  best execution: “trading process Firms apply that seeks to maximize the value of a client’s portfolio within the client’s stated investment objectives and constraints.”  intrinsically tied to portfolio-decision value and cannot be evaluated independently   prospective, statistical, and qualitative concept that cannot be known with certainty ex ante  has aspects that may be measured and analyzed over time on an ex post basis, even though such measurement on a trade-by-trade basis may not be meaningful in isolation  interwoven into complicated, repetitive, and continuing practices and relationships Trade Management Guidelines: o  1. processes: formal policies and procedures aimed at best execution, and then measure  2. disclosures: general info on trading techniques and on conflicts of interest  3. record keeping: showing compliance w/ firm policies and showing necessary disclosures Importance of Ethical Focus: any trader who does d oes not adhere to his word quickly finds that no one is willing to deal with him; loyalty to client

Reading 45: Monitoring and Rebalancing Monitoring: Investor Circumstances and Constraints: changes in investor circumstances and wealth o changing liquidity requirements o changing time horizons o tax circumstances o o changes in laws and regulations o unique circumstances: say emotional ties to holding or SRI (socially responsible investing) Market and Economic Changes: Changes in asset risk attributes: mean return, volatility, correlations o o market cycles: tactical adjustments o central bank policy o yield curve and inflation Monitoring the portfolio: events and trends affecting prospects of individual holdings and asset classes o changes in asset values that create unintended divergences from client’s strategic asset allocation o •

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Rebalancing the Portfolio: 1. adjusting portfolio po rtfolio to strategic allocation; 2. changes from changes to investor’s objectives and constraints or capital capital market expectations; 3. tactical asset allocation. here, discuss only 1. cost/benefit: drifts from strategic allocation results in expected ex pected utility loss o level of portfolio risk may drift upward (higher risk returning more and taking greater % of portfolio) o drift toward holding over priced assets o  rebalancing by selling appreciated assets and buying depreciated assets can be seen as contrarian o transaction costs:  explicit costs illiquid assets; but may be able to accomplish some of rebalancing through cash flows  implicit costs  bid-ask spread market impact •

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tax costs: incur short- or long-term capital gains; reduces deferral benefit from long-term capital gains Rebalancing disciplines: Calendar rebalancing: on periodic basis o Percentage-of-Portfolio Rebalancing: o  ad hoc approaches: say +/- 5% points of target allocation, or +/- 10% of target allocation %: target +/- (target allocation x P%).  ad hoc doesn’t account for 1. transaction costs; 2. risk tolerance: tracking risk v. strategic asset allocation; 3. correlation; 4. volatility; 5. volatilities of other asset classes o

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Factors Affecting Optimal Corridor Width Factor Effect on Optimal Width of Corridor (All Else Equal) Factors positively related to optimal corridor width The higher the transactions costs, the wider  Transaction costs the optimal corridor  The higher the risk tolerance, the wider the Risk tolerance optimal corridor  The higher the correlation, the wider the Correlation w/ rest optimal corridor  of portfolio Factors inversely related to optimal corridor width The higher the volatility of a given asset Asset class class, the narrower the optimal corridor  volatility Volatility of rest of  portfolio

The higher this volatility, the narrower the optimal corridor 

Intuition

High transaction costs set a high hurdle for  rebalancing benefits to overcome Higher risk tolerance means less sensitivity to divergences from target When asset classes move in synch, further  divergence from targets is less likely A given move away from target is potentially more costly for a high-volatility asset class, as a further divergence becomes more likely Makes large divergences from strategic asset allocation more likely

Calendar-and-Percentage-of-Portfolio Rebalancing: monitor say quarterly and rebalance only if % outside corridor  Equal Probability Rebalancing: corridor for each asset class as a common multiple of standard o deviation of asset class’s return Tactical rebalancing: calendar rebalancing but less frequent when markets trending and more frequent o when reversal occurring rebalancing to target weights v. to allowed range: latter allows from tactical adjustments; better manage weights of relatively illiquid assets setting optimal thresholds: minimize expected utility losses and transaction costs o

•

•

Perold-Sharpe Analysis of Rebalancing Strategies: Buy-and-Hold Strategies: buy risky asset and risk-free asset and do nothing o  portfolio value = investment in stocks + floor value (e.g., risk free asset value) upside is unlimited, but portfolio value can be b e no lower than allocation to bills o o  portfolio value is linear function of value of stocks, and portfolio return is linear function of return on stocks value of stocks reflects cushion (above floor value) o implication of using this strategy is that investor’s risk tolerance is positively related to wealth and o stock market returns. risk tolerance is zero zero if value of stocks declines to zero. Constant-Mix Strategies: always rebalancing; contrarian and supplies liquidity Target investment in stocks = m x portfolio value o consistent w/ risk tolerance that varies proportionately w/ wealth o •

•

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•

Constant-Proportion Strategy: CPPI: dynamic strategy in which target equity allocation is function of value of   portfolio less floor value: Target investment in stocks = m x (portfolio value – floor value) o consistent w/ zero tolerance for risk when cushion is zero o if m is greater than 1, then: constant-proportion portfolio insurance (CPPI) o  consistent w/ higher tolerance for risk than buy-and-hold strategy  sell shares as stock value declines and buy shares as stock values rise

Relative Return Performance of Different Strategies in Various Markets Market Condition Constant Mix Buy and Hold Up Underperform Outperform Flat (but oscillating) Outperform Neutral Down Underperform Outperform Investment Implications Payoff curve Concave Linear Portfolio insurance Selling insurance None Multiplier 0
CPPI Outperform Underperform Outperform

Convex Buying insurance m>1

Execution Choices in Rebalancing: cash market trades: actually transact in the asset: more costly and slower  derivative trades: say futures Ks and total return swaps; lower transaction costs; rapid implementation; leaves active managers’ strategies undisturbed • •

Reading 46: Evaluating Portfolio Performance Fund Sponsor’s Perspective: enhances effectiveness of fund’s investment policy by acting as feedback and control mechanism Investment Manager’s Perspective: feedback and control co ntrol loop, helping to monitor proficiency of various aspects o f   portfolio construction process 3 components of performance evaluation: 1. account’s performance? (performance measurement) 2. why did account  produce observed performance? (performance attribution) 3. luck or skill? (performance appraisal) Performance Measurement: w/o intraperiod external cash flows MV 1 − MV 0 r t  = o MV 0 •

• •

o

cash flow at start of period: r t 

=

o

cash flow at end of period: r t 

=

MV 1 − ( MV 0

+ CF )

+ CF  ( MV 1 − CF ) − MV 0 MV 0

MV 0

Total Rate of Return: measures increase in investor’s wealth due to both investment income and capital gains Time-Weighted Rate of Return (TWR): compound rate of growth over stated evaluation period of one unit of  money initially invested in the account; requires account be valued every time external CF occurs o chain linking: create wealth relative by adding return to 1; multiply all wealth relatives for cumulative wealth relative; subtract one; or take to time period power to weight by time requires valuation on each date of CF o 40963581.doc 100 of 114

•

Money-Weighted Rate of Return (MWR): the IRR  o

• •

MV 1

m − L ( n ) = MV 0 (1 + R ) m + CF 1( 1 + R) m− L (1) +... ... + CF n (1 + R)

Linked Internal Rate of Return: take MWR of frequent periods and chain-link those (account valuations should be reported on trade-date, fully accrued basis: that is stated value of account should reflect impact of unsettled trades and any income owed by or to the account accoun t but not yet paid)

Benchmarks: P = M + S + A: portfolio performance is equal to market return plus style return (together the benchmark  return) plus the active management return Properties of Value Benchmark: o unambiguous investable o measurable o appropriate o reflective of current investment opinions o specified in advance o owned o Types of Benchmarks: absolute: say a return objective; not investable and not really valid benchmark  o manager universes: median manager or fund from broad universe; measurable, but not otherwise valid o  benchmark   critique of median manager benchmark: not investable, is ambiguous, can’t verify appropriateness, subject to survivor bias Broad market indexes: say S&P 500; may not reflect style o Style Indexes: still may not reflect manager’s style o Factor-Model-Based: o  market model is one factor (beta)  normal portfolio: portfolio w/ exposures to sources of systematic risk that are typical for  manager, using manager’s past portfolios as guide Returns-Based: constructed using 1. series of manager’s account returns (ideally monthly and back to o  beginning) and 2. series of returns on several investment style indexes over same period; allocation algorithm solves from combination of investment style indexes that most closely tracks account’s return Custom Security-Based: simply manager’s research universe weighted in a particular fashion o  Building custom security-based benchmarks: steps: identify prominent aspects of manager’ investment process select securities consistent w/ investment process devise weighting scheme for benchmark securities, including cash position review preliminary benchmark and make modifications rebalance benchmark portfolio on predetermined schedule o Tests of Benchmark Quality:  minimal systematic biases or risks in benchmark relative to account  tracking error: should reduce noise in performance evaluation process  risk characteristics: should systematically differ over time (okay to rotate from greater and lesser, but shouldn’t stay on one side)  coverage: should have high overlap of securities  turnover: of the benchmark: if too high, then not really investable •

•

•

• • • • •

40963581.doc 101 of 114



o

 positive active positions: high proportion of positive active positions is good; high proportion of negative active positions indicates not very good benchmark fit Hedge Funds and Hedge Fund Benchmarks: tend to be “absolute return”, have investment strategies that incorporate high degree of optionality (skewness), but usually have clearly definable investment universes

Performance Attribution: identifies differential returns (on fund sponsor level: macro attribution; on investment manager level: micro attribution) Impact equals (active) weight times return Macro Attribution: 1. policy allocations; 2. benchmark portfolio returns; and 3. fund returns, valuations, and external cash flows o analysis: break return down to 6 levels:  1. net contributions: net cash inflows/outflows (basically starting point)  2. risk-free asset: as if all invested in risk-free asset  3. asset categories: incremental return over risk-free return from policy asset allocation: • • •

 A

r  AC 

= ∑ wi × ( r Ci − r   f   ) ; (if stopped here, would be all-passive approach) i =1



4. benchmarks: incremental return from weighted average benchmark returns:  A

r  IS 

=∑ i =1

M 

∑w × w i

  j =1

ij

× ( r  Bij − r Ci ) ; calculated by multiplying each manager’s policy proportion

of the total fund’s beginning value and net external cash inflows by difference d ifference b/w the manager’s benchmark return and the return of the manager’s asset category, and then summing across all managers; (if stop here, would be passive in the benchmark)  A



•

5. investment managers (value of active management): r  IM 

=∑ i =1

M 

∑w ×w i

  j =1

ij

× ( r  Aij − r  Bij ) ;

assumes that fund sponsor has invested in each of the managers according to managers’ policy allocations  6. allocation effects: incremental contribution from difference b/w fund’s ending value and value calculated at investment manager level Micro attribution: investment results of individual portfolios relative to designated benchmarks n

o

value added: r v

= ∑[( w pi − w Bi ) × ( r i − r  B ) ] ; from both differing weights and differing returns from i =1

o

securities selection: outperform only if both positive or both negative; underperform if one negative and other positive (e.g., overweighting underperforming securities, or underweighting outperforming securities) factor models (instead of looking at each individual security): market model is just beta.  sector weighting/stock selection micro attribution: return may be weighted sum of sectors: and thus difference to actual return is from •

security selection: r v •

S 

S 

  j =1

  j =1

= ∑w pj r  pj − ∑w Bj  Bj r   Bj  Bj

 based on buy and hold: so category for trading and other to catch these effects S 

•

r v

S 

S 

= ∑( w − w )( r  − r  ) + ∑ ( w − w )(r  − r  ) + ∑ w (r  − r  )  pj

 Bj

 Bj

  j =1

 B

  

 PureSector   Allocation o

 pj

 Bj

 pj

 Bj

  j =1

  

 Allocation / SelectionI  nteraction

 Bj

  j =1

 

 pj

 Bj



Within −SectorSele ction

 pure sector allocation return: equals difference b/w allocation (weight) o f   portfolio to given sector and portfolio’s benchmark weight for that sector, times 40963581.doc 102 of 114

o

the difference b/w the sector benchmark’s return and an d the overall portfolio’s  benchmark return, summed across all sectors within-sector selection return: equals difference b/w return on portfolio’s o holdings in given sector and return on corresponding sector benchmark, times weight of benchmark in that sector, summed across all sectors o allocation/selection interaction return: joint effect of portfolio managers’ and security analyst’s decisions to assign weights to both sectors and individual securities: difference b/w weight of portfolio in given sector and portfolio’s  benchmark of that sector, times difference b/w portfolio’s and ben chmark’s returns in that sector, summed across all sectors  can also have factor model based on fundamentals: company’s size, industry, growth characteristics, financial strength, and other factors Fixed Income Attribution:  instead of sectors: gov’t bonds, agency and investment-grade corporate credit bonds, high-yield  bonds, mortgage-backed securities, etc.  determinants: changes in general level of interest rates; changes in sector, credit quality, individual security differentials or nominal spreads to yield curve  yield curve twists, steepening, flattening  Total portfolio return: effect of external interest environment o return of default-free benchmark assuming no change in forward rates o return due to change in forward rates contribution of management process: return from interest rate management: performance from predicting interest rate o changes (also duration, convexity, and yield-curve shape change) return from sector/quality management: from selecting right issuing sector and o quality group return from selection of specific securities: specific securities w/i sector  o return from trading activity: effect from sales and purchases (residual) o •

•

Performance Appraisal: skill? (investment skill: ability to outperform appropriate benchmark consistently over time) Risk-Adjusted Performance Appraisal Measures: ex post alpha (Jensen’s alpha):  R At  − r   ft  = α  A + β  A ( RMt  − r   ft  + ε t  ; alpha is the measure o • •

o

Treynor measure (reward-to-volatility or excess return to nondiversifiable risk): T  A

=  R A ˆ− r   f   ; bars β  A

indicate average values over time o

o

Sharpe ratio (reward to variability): S  A

•

 R A

− r   f  

ˆ  A σ  M2: mean incremental return over market index of hypothetical portfolio formed by combining account w/ borrowing or lending at risk-free rate so as to match standard deviation of market index; measures what account would have returned if it had taken on the same total risk as market index:

M  A2 o

=

  R − r    σ ˆ M  = r   f   +   A   f       ˆ σ     A  

Information ratio:  IR A

=

 R  A − R B ˆ  A− B σ 

Quality Control Charts: 40963581.doc 103 of 114

o

cumulative annualized value-added: x-axis x -axis is time and y-axis is benchmark return; alpha will be a  jagged line around the benchmark return (set to zero); funnel-shaped confidence interval set around  benchmark return; skill would be expected to exceed the benchmark return and (at least some of the time) be outside of the confidence funnel.  if inside the funnel, then can’t reject null hypothesis that manager has no skill.

Practice of Performance Evaluation: 6 criteria for manager selection (among finalists): o 1. physical: organizational structure, size, experience, other resources o 2. people: investment professionals, compensation o 3. process: investment philosophy, style, decision making 4. procedures; benchmarks, trading, quality control o 5. performance: results relative to an appropriate benchmark  o 6. price: investment management fees o manager continuation policies (MCP): policy for deciding whether to replace a manager  o manager monitoring: identify warning signs o manager review: if manager monitoring identifies item of sufficient concern to trigger review o MCP as filter: null hypothesis is that managers under evaluation are best zero-value-added managers:  Type I error: keeping (or hiring) managers w/ zero value-added (rejecting null hypothesis when it is correct); (course filter creates this error)  Type II error: firing (or not hiring) managers w/ positive value-added (not rejecting null hypothesis when it is incorrect); (fine filter creates this error) •

•

Reading 47: Global Performance Evaluation Performance Attribution in Global Performance Evaluation: return in local currency: capital gains in percent plus dividend yield return in base currency: • •

V   jt S   jt 

+ D  jt  S   jt  −V   jt −1S   jt −1

o

r   j 0

=

o

r   j 0

=  p  j + d   j + s  j (1 +  p  j + d j

V   jt −1S   jt −1

; or  r   j 0 =  p  j + d   j + c  j

•

total return is weighted average return of returns of all segments:

•

Performance Attribution: o

o

=  I   j + ( p  j − I   j + d   j + c j r  = ∑w  j I   j + ∑w  j

∑w  p + ∑w d  + ∑w c   j

  j

  j

  j

  j

  j

  j

  j

  j

r   j 0

  j

 p  j

− I   j

  j

    

   

Market  Re turnCompan ent  ent  o

r  =

SecuritySe lectionCon tribution

+

∑w d    j

  j

  j

+

∑w c

  j   j

  j

    

YieldCompo nent 



CurrencyCo mponent 

Asset allocation:

r = 

∑ w j I  j *

 j

0

   

+

∑ ( w − w  I ) + ∑ ( w c − w C  ) + ∑ w ( p −  I  ) + ∑ w d  *

 j

*

 j  j

 j

   

 j  j

 j

 j  j



 j  j

 j

 j

   

 j  j

 j



 I n'lt B e n c h Rm teau r *k n I  M a r k ect aA t li loo n rCi bo un tt i o Cn u r r e nl oc cy aA t l i on nt rCi bo u2 t i oSn e c u r liet yc St ieo nt rCi bo un t i oY ni e l d C noemn 

o

here I j0 is return on market index j, translated into base currency 0: I j0 = I j + C j can also attribute based on:  Market timing  Industry and Sectors 40963581.doc 104 of 114



Factors and Styles  Risk Decomposition Measuring active currency exposure relative to benchmark: o  any deviations from benchmark should be thought of as active exposure  using derivatives:   f   linear approximation for forward sale: c  j = s  j + R  j − R0 : exchange rate movement plus interest rate differential  overall currency component is sum of: 1. currency component of passive benchmark; 2. currency allocation contribution; 3. return on currency hedges hed ges Multiperiod Attribution Analysis: o correct multiperiod attribution is not equal to either simple sum of individual periods or compound return of individual periods; two-period attribute can be decomposed into first-period attribution compounded at second-period o  benchmark rate of return plus the second-period secon d-period attribution compounded at the first-period portfolio rate of return o  performance evaluation services may use different methods of allocating cross products •

•

Performance Appraisal in Global Performance Evaluation: Risk: 1. calculate absolute risk; 2. calculate risk relative to benchmark  Absolute: • •

o

σ total 

=

T 

1

∑(r  − r ) T  −1

2

t 

; if monthly, annualize by multiplying by

12

t =1

•

Relative risk: Tracking Error: o

•

•

•

σ er  =

1

T 

∑ (er  − er ) T  − 1 t =1

2

t 

Risk-Adjusted Performance: Sharpe ratio o Treynor ratio o Jensen measure o (consider problems from what constitutes “passive” world market portfolio) o Information ratio o Risk Allocation and Budgeting: 1. absolute risk allocation among asset classes; 2. active risk allocation of  managers in each asset class Potential Biases in Risk and Return: infrequently traded assets o option-like investment strategies o survivorship bias: return o survivorship bias: risk  o

Implementation of Performance Evaluation:  benchmarks: consider  individual country/market weights o countries, industries, and styles: industry factors have grown in importance o o currency hedging: publicly available market indexes are generally not hedged against currency movements Reading 48: Global Investment Performance Standards •

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GIPS governance: GIPS Executive Committee (formerly Investment Performance Council) i. Four standi standing ng subcom subcommit mittee tees: s: GIPS Council: works w/ Country Sponsors in development, promotion and maintenance of standards Interpretations Subcommittee: provides guidelines for new issues Practitioners/Verifiers Practitioners/Verifiers Subcommittee: forum for 3rd-party service providers who apply and implement GIPS Investors/Consultants Subcommittee: forum for end-users of GIPS info •

•

• •

•

GIPS: Preface: Background of the GIPS Standards I. Introduction a. Preamb Preamble: le: Why Why Is Is a Globa Globall Standar Standard d Needed Needed??  b.  b. Visi Vision on Sta State teme ment nt c. Objectives ves d. Overview e. Scope f. Compliance g. Implem Implement enting ing a Glob Global al Standar Standard d II. II. Provi Provisi sion onss of the the Glo Globa ball Inves Investm tmen entt Per Perfo form rman ance ce Stan Standar dards ds 0. Funda Fundame ment ntal alss of Comp Compli lianc ancee 1. Input Da Data 2. Calc Calcul ulat atio ion n Meth Methodo odolo logy gy 3. Comp Compos osit itee Const Constru ruct ctio ion n 4. Disc Disclo lossures ures 5. Pres Presen enta tati tion on and and Report Reportin ing g 6. Real Es Estate 7. Pri Private vate Equ Equiity III. Verification a. Scope Scope and and Purpo Purpose se of Verifi Verificati cation on  b. Requir Required ed Veri Verific ficati ation on Proce Procedur dures es c. Detailed Detailed Examina Examinations tions of Invest Investment ment Performance Performance Presentati Presentations ons Appendix A: Sample GIPS-Compliant Presentations Appendix B: Sample List and Description of Composites Appendix C: GIPS Advertising Guidelines Appendix D: Private Equity Valuation Principles Appendix E: GIPS Glossary GIPS: Preface: Background of the GIPS Standards IV. Introduction a. Preamb Preamble: le: Why Why Is Is a Globa Globall Standar Standard d Needed Needed??  b.  b. Visi Vision on Sta State teme ment nt c. Objectives ves d. Overview i. Firms required required in include include “all actual actual fee-paying, fee-paying, discretio discretionary nary portfolios portfolios in aggregates aggregates,, known as composites, defined by strategy or investment objective. ii. Show history history for for min of 5 yrs yrs or since since inception, inception, and then then add on yrs to build build 10-yr record record e. Scope 40963581.doc 106 of 114

V.

f. Compliance g. Implem Implement enting ing a Glob Global al Standar Standard d Provi Provisi sion onss of the the Glo Globa ball Inves Investm tmen entt Per Perfo form rman ance ce Stan Standar dards ds 0. Funda Fundame ment ntal alss of Comp Compli lianc ancee i. Must be firm-wide firm-wide basis; basis; the the firm: “an “an investment investment firm, firm, subsidiary subsidiary,, or division division held out to clients or potential clients as a distinct business; a distinct business entity is a “unit, division, department, or office that is organizationally and functionally segregated from other units, divisions, departments, or offices and retains discretion over the assets it manages and should have autonomy over the investment decision-making process. ii. Must document document in writing writing policies policies and procedure proceduress used in establis establishing hing and maintainin maintaining g compliance w/ GIPS iii. Compliance Compliance statement: statement: “[Name “[Name of firm] firm] has prepared prepared and presente presented d this report report in compliance compliance ® with the Global Investment Performance Standards (GIPS ).” iv. Must “make “make every reasonabl reasonablee effort” effort” to provide all all prospective prospective clients clients w/ a compliant compliant  presentation v. Must provide provide a list and and description description of all composit composites es to any prospecti prospective ve client asking, asking, and must  provide upon request compliant presentation for any composite listed. Discontinued must stay on list for 5 yrs. vi. Recommends Recommends verifica verification tion (which (which must be firm-wide) firm-wide).. Verificati Verification on language: language: “[Name “[Name of firm] firm] has been verified for the periods periods [dates] by [name of verifier]. A copy of the verification verification report is available upon request.” 1. Input Da Data i. All data data and and info info necessary necessary … captured captured and maintai maintained ned ii. Portfolio Portfolio valuations: valuations: market market rather rather than than cost cost or or book  book  iii. Trade-date Trade-date accounting accounting req’d: req’d: the “transact “transaction ion is reflecte reflected d in the portfolio portfolio on the date of the  purchase or sale, and not on the settlement date.” iv. Accrual Accrual accounting accounting req’d for fixed-in fixed-income come securitie securitiess and other assets assets that accrue accrue interest interest v. Frequency Frequency and timing timing of portfolio portfolio valuations valuations:: beginning beginning 1/1/10: on the date date of all large large external external cash flows; and as of the calendar ca lendar month-end or the last business day of the month 2. Calc Calcul ulat atio ion n Meth Methodo odolo logy gy i. Time-Weight Time-Weighted ed Total Total Return Return adjusted adjusted from cash flows flows req’d: req’d: MV 1 − MV 0 1. simp simple lest st form form:: r t  = MV 0 2. when external external cash cash flows: flows: “value “value portfolio portfolio whenever whenever an external external cash cash flow flow occurs, occurs, compute a subperiod return, and geometrically chain-link subperiod returns expressed ... × (1 + r t , n ) −1 ; r t,1 in relative form: r twr  = (1 + r t ,1 ) × (1 + r t , 2 ) ×... t,1 through r t,n t,n are subperiods. 3. (used to to be able to use use from 1/1/05 1/1/05 until until 1/1/10 1/1/10 the Original Original Dietz Dietz method method reflectin reflecting g MV 1 − MV 0 − CF  midpoint assumption: r  Dietz  = MV 0 + ( 0.5 × CF ) 4. daily weighted weighted CFs required required after after 1/1/05 1/1/05 but not after after 1/1/10: 1/1/10: MV 1 − MV 0 − CF  CD −  Di a. Mo Modi diffied Di Dietz: etz: r ModDietz  = ; wi = where CD is MV 0 + ( CF i × wi ) CD

∑

total calendar days in month and D is the # of days from beginning of month that CF occurs (so 5 for CF on the 5th).  b. Mod Modifi ified ed or Linked Linked IRR: IRR: solve solve for for r: r: MV 1 =

∑ CF i × (1 + r )

wi

+ MV 0 (1 + r )

5. returns returns from cash cash and cash-equi cash-equivalent valentss must be include included d in total return return calcula calculations tions 6. returns returns must be calculate calculated d after deduction deduction of actual—not actual—not estimat estimated—tra ed—trading ding expenses expenses (but not custody fees) 40963581.doc 107 of 114

a. if bundled bundled fees fees (all-in (all-in fees fees and wrap wrap fees) fees) and not not extricabl extricable, e, then deduct deduct entire entire fee 7. recommendat recommendation: ion: calculate calculate returns returns net of nonreclai nonreclaimable mable withholdi withholding ng taxes on dividends, interest and capital gains (but accrue reclaimable withholding taxes) 8. Composite Composite return return calc standards: standards: “Compos “Composite ite returns returns must be calculat calculated ed by assetweighting the individual portfolio returns using beginning-of-period values or a method that reflects both beginning-of-period values and external cash flows.” a. Denominator Denominator of method method using beginning-val beginning-value ue plus plus external external CFs: V  p

= MV 0 + ∑( CF i × wi )

  MV 0, pi     = ∑ r  pi × ∑ MV 0, pi        V  pi     compos composit itee return return using using beginn beginning ing and and externa externall CFs: r C  = ∑  r  pi × V  ∑  pi     

 b. So, compo composit sitee return return using using just just beginni beginning: ng: r C  c.

d. after 1/1/10, 1/1/10, composi composite te returns returns must must be calculated calculated monthly monthly using using monthly monthly assetassetweighting. 3. Compos Composit itee Constru Constructi ction: on: “All “All actu actual, al, fee-paying , discretionary portfolios must be included in at least one composite. Although non-fee-paying discretionary portfolios portfolios may be included included in a composite (with appropriate disclosures), nondiscretionary portfolios are not permitted to be included in a firm’s composites.” i. Discretion Discretionary: ary: if the the manager is able able to implement implement the intended intended investment investment strateg strategy. y. Restrictions that impede investment process to extent that strategy cannot b e implemented as intended: presumed nondiscretionary. ii. Defining Defining investment investment strategi strategies: es: must be defined defined according according to similar investmen investmentt objectives objectives and/or strategies, and the full composite definition as documented in the firm’s policies and  procedures must be made available upon request. 1. suggested suggested hierarch hierarchy: y: Investment Investment Mandate Mandate | Asset Asset Classes Classes | Style Style or Strateg Strategy y| Benchmarks | Risk/Return Characteristics iii. including including and excluding excluding portfolios portfolios:: must include include new portfoli portfolios os on a timely and consist consistent ent  basis after the portfolio comes under management unless specifically mandated by the client. Preferably, beginning of next full performance measurement period. Must include terminated terminated  portfolio in historical record of the appropriate composite up to last full measurement period. 1. cannot be switc switched hed from one one composite composite to another another unless unless documented documented changes changes in client client guidelines or the redefinition redefinition of the composite make it appropriate. Historical record must remain in composite. 2. recommendat recommendation: ion: event of signifi significant cant external external CFs, use use temporary temporary new accounts accounts rather  rather  than temporarily removing portfolios portfolios from composites. composites. May be compelled to temporarily remove portfolios from composites when large external CFs occur. 3. if minimum minimum asset asset level threshold threshold for for inclusion, inclusion, must must strictly strictly follow follow that policy: policy: none  below can be included. May require time threshold threshold so that temporarily temporarily devalued  portfolios don’t go in in and out of composite. Any changes to minimum threshold: threshold: cannot be applied retroactively. Firm should not market composite composite to prospective clients falling below minimum threshold. iv. Carve-Outs: Carve-Outs: cannot cannot exclude exclude cash; “When “When a single asset asset class class is carved out of a multipl multiplee asset class portfolio and the returns are presented as part of a single asset composite, cash must be allocated to the carve-out returns in in a timely and consistent consistent manner.” 2 acceptable cash allocation methods: “Beginning of period allocation” and “Strategic asset allocation” (for  strategic: the cash amount is the deviation for the target: so 2.5% when target is 37.5% and actual is 35%.). From 1/1/10, carve-out returns cannot be included in single-asset-class single-asset-class

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composite returns unless the carve-out is actually managed separately with its own cash  balance. 4. Disc Disclo lossures ures i. Def of “firm”; “firm”; if re-defined re-defined,, disclose disclose date date and re-def  re-def  ii. All signifi significant cant events events that that help interpr interpret et performanc performancee record record iii. iii. Use of suba subadvi dvisor sorss and period periodss for which which used used iv. Make available available complete complete list list (last (last 5 yrs) and and descripti description on of all composit composites es v. Recomm Recommend ended: ed: disclo disclose se firms firms w/I paren parentt company company vi. Recommended: Recommended: if if verified, verified, disclo disclose se and periods periods verified verified if not all vii. Currency Currency to express express performance; performance; disclos disclosee and describe describe exchange rate rate inconsistenc inconsistencies ies among composites and b/w composite and benchmark  viii. viii. Treatm Treatment ent of withhol withholdin ding g tax tax ix. Tax basis basis of benchmar benchmark k vs. composite composite (Lux vs. U.S.) U.S.) x. Disclose Disclose availabilit availability y of add’l info info on calc and reporting reporting returns returns (e.g., (e.g., methodology methodology,, valuation valuation sources, treatment of large external CFs) xi. Recommended: Recommended: disclos disclosee when change change of calc methodolog methodology y or valuation valuation sources sources has has material material impact xii. Fees: clearly clearly label label returns returns gross of or net net of; for gross gross of, also also disclose disclose whether anything anything other  other  than direct trading expenses deducted; for net of, also disclose whether anything other than direct trading expenses and investment management fee deducted; disclose appropriate fee schedules; if bundled-fee, present % of portfolios for each annual period that are such and disclose various types of bundled fees. xiii. xiii. Investment Investment objectives objectives,, style, and strategy strategy of composite composite (more than than broadly indicati indicative ve name) xiv. xiv. Comp Compos osit itee crea creati tion on date date xv. Measur Measuree of dispe dispersi rsion on and whic which h measur measuree xvi. If minimum minimum asset level level for inclusi inclusion on in composite, composite, disclose disclose minimum minimum and any changes changes thereto thereto xvii. Presence, Presence, use and extent extent of leverage leverage or derivatives, derivatives, if materi material, al, including including use, frequency frequency and and characteristics of instruments xviii. xviii. Whether Whether conforms conforms to local laws and and regs that differ differ from from GIPS, and disclos disclosure ure of such conflict conflict 5. Pres Presen enta tati tion on and and Report Reportin ing g i. Show at least 5 yrs and extend extend thereaft thereafter er until until 10 yrs yrs ii. Annual returns returns (calendar (calendar yr unless unless noncalend noncalendar ar fiscal fiscal yr); number number of portfolios portfolios;; amount of  assets in composite; % of total firm assets composite represents or total firm assets; measure of  dispersion of individual portfolio returns if >=6 portfolios (high/low, interquartile range, standard deviation) iii. Can link to to prior-to-1/ prior-to-1/1/00 1/00 non-GIPSnon-GIPS-compli compliant ant performanc performancee if disclosed disclosed iv. Cannot Cannot annual annualize ize partia partial-y l-year ear retur returns ns v. “por “porta tabi bili lity ty”” 1. Prior affili affiliation ation performanc performancee must be linked linked if: 1. substanti substantially ally all the the investment investment decision-makers are employed by the new firm; 2. staff and decision-making process remain intact and independent w/ the new firm; and 3. new firm has records that document and support the reported performance. 2. linki linking ng mus mustt be dis discl clos osed ed 3. can be linked linked if: substantia substantially lly all of the the assets from from past firm’s firm’s composit compositee transfer transfer to the new firm 4. one yr to to comply comply if GIPS-com GIPS-compliant pliant firm acquir acquires es noncompliant noncompliant firm vi. single-ass single-asset-cl et-class ass carve-outs carve-outs from multiple-ass multiple-asset-cl et-class ass portfolios: portfolios: presentati presentation on must include % of composite that is composed of carve-outs carve-o uts from 1/1/06 forward. vii. Benchmarks: Benchmarks: benchmark benchmarkss reflecting reflecting composite composite’s ’s investment investment strategy strategy or mandate mandate must must be  presented for each annual period; if none shown, must explain why; dates and reasons for  40963581.doc 109 of 114

changes of benchmarks must be presented; for custom benchmarks, describe benchmark  creation and rebalancing process; once established, rebalancing must be consistently applied viii. viii. If composite composite includes includes any non-fee-p non-fee-paying aying portfol portfolios, ios, must must present % of composi composite. te. ix. Recommended: Recommended: present present composit compositee performance performance gross gross of investm investment ent management management and and administrative fees and before taxes except for nonreclaimable withholding taxes. x. Recommended: Recommended: present present cumulati cumulative ve composite composite and and benchmark benchmark returns returns xi. Recommended: Recommended: present present equal-wei equal-weighted ghted mean mean and median median returns returns for each each composite composite xii. Recommended: Recommended: present present composi composite-l te-level evel country country and and sector sector weighting weightingss xiii. xiii. Recomm Recommend ended: ed: prese present nt chart chartss and graphs graphs xiv. Recommended: Recommended: present present risk measures: measures: beta, beta, tracking tracking error, modified modified duration, duration, informatio information n ratio, Sharpe ratio, Treynor ratio, credit ratings, value at risk and volatility or variability of  composite and benchmark  6. Real Es Estate i. Publicly Publicly traded traded real estate securitie securities, s, securities securities issued issued by public companies, companies, CMBSs CMBSs and private debt investments (including commercial and residential loans for which the expected return is solely related to contractual interest rates w/o any participation in the economic performance of  the underlying real estate) are treated under the regular GIPS standards and not the real estate standards. Portfolio holding holding both must carve out. ii. Despite Despite regular GIPS, GIPS, must be valued valued quarterly quarterly internal internally ly or externally externally,, valued every 12 months externally and “Real estate investments must be valued by an external professionally designated, certified or licensed commercial property valuer/appraiser at least once every 36 months.” iii. Must present present methods, methods, sources, sources, and frequency frequency of valuatio valuations; ns; also asset-we asset-weighte ighted d % of  composite real estate assets valued by an external ex ternal valuation for each period as well w ell as frequency w/ which real estate investments are valued by external valuers. iv. Must describe describe definition definition of discretion; discretion; generall generally: y: if manager has sole sole or primary responsib responsibilit ility y for major investment decisions. v. Must present present total total return w/ income income and capital capital appreciati appreciation on breakdown; breakdown; and calculatio calculation n methodology (e.g., whether chain-linked time-weighted; or adjusted to make the capital return and income return equal total return); adjust for time-weighted cash flows 1. capi capita tall empl employ oyed ed:: C  E  = C 0 + ( CF i × wi ) ( MV 1 − MV 0 ) −  E C  + S  2. capi capita tall retu return rn:: r c = ; where E is capital expenditures and S is C  E 

∑

sale proceeds 3. incom ncomee ret retur urn: n: r  I 

=

 INC  A

−  E  NR −  INT  D − T  C  E 

; INC is income accrued, E is

nonrecoverable expenditures, INT is interest on debt and T is property taxes 4. total otal ret return: urn: r T = r C + r I vi. recommended: recommended: present present capital capital and income segments segments of the the appropriate appropriate real real estate estate benchmark  benchmark  vii. recommended: recommended: annual/annual annual/annualized ized since-incept since-inception ion IRR for composite: composite: SI-IRR; SI-IRR; should should disclose time period and frequency of cash flows; should use quarterly cash flows at minimum. viii. viii. Recommended: Recommended: present present time-weig time-weighted hted rate of return return and SI-IRR SI-IRR gross gross and net of fees, and reflecting ending market value and also reflecting only realized cash flows excluding unrealized gains. 7. Pri Private vate Equ Equiity i. Open-end Open-end and evergreen evergreen funds funds subject subject to regular regular GIPS standar standards ds and not PE PE standards standards ii. Privat Privatee Equity Equity Valua Valuati tion on Princi Principal palss 1. obligate obligate firms firms to ensure that that valuations valuations are prepared prepared w/ integri integrity ty and professio professionalis nalism m by individuals w/ appropriate experience and ability ab ility under direction of senior management and in accordance w/ documented review procedures 40963581.doc 110 of 114

2. 3. 4. 5. 6.

VI.

valuat valuation ion basis basis must must be be divul divulged ged clearly clearly discl disclose ose methodologie methodologiess and key assumption assumptionss logica logically lly cohes cohesive ive and rigor rigorous ously ly applie applied d must recognize recognize events events that diminish diminish an an asset’s asset’s value present present on consistent consistent and and comparable comparable basis basis from one period period to to next; any change in valuation basis or method must be disclosed 7. valuations valuations at least least annuall annually, y, but quarterly quarterly recommended recommended 8. recommended: recommended: valuations valuations on on fair fair value value basis; basis; hierarchy: hierarchy: a. market market transacti transactions ons (e.g., (e.g., most most recent recent arms-l arms-length ength financi financing) ng)  b.  b. mark market et-b -bas ased ed mult multip iple less c. risk-a risk-adju djuste sted d discount discounted ed expecte expected d cash flows flows iii. must disclose disclose net-of-fe net-of-fees es (including (including net of carried carried interest, interest, investment investment management management fees and transaction expenses; net of investment advisors fees … if app licable) and gross-of-fees SI-IRR  of composite for each year; use daily or monthly CFs and end-of-period valuation of  unliquidated holdings remaining in composite; stock distributions valued at time of distribution iv. all closed-end closed-end PE investme investments nts to be included included in composite composite defined defined by strategy strategy and vintage vintage year; direct investments and investments made through other funds or p’ships must be in separate composites v. must must di discl sclose: ose: 1. vint vintag agee year yearss, 2. composi composite te invest investmen mentt stra strateg tegy, y, 3. total total commit committed ted capit capital al for for compos composite ite,, 4. valuat valuation ion metho methodol dologi ogies es and change change ther thereof eof,, 5. if also also compli complies es w/ local or regional regional guidelines, guidelines, 6. that valuation valuation review review procedures procedures are are availab available le upon upon request request 7. if fair fair value not used, why, why, number of investm investments ents not fair fair valued valued and their their carrying carrying value in absolute amount and relative to total fund 8. unrealized unrealized appreciat appreciation ion or depreciat depreciation ion of composite composite for for most recent recent period period 9. whethe whetherr using using daily daily or month monthly ly CFs CFs for SI-IR SI-IRR  R  10. if benchmarks disclosed, disclosed, disclose calc methodology for benchmark and cumulative annualized SI-IRR; if no benchmark disclosed, explain why 11. if not calendar, calendar, disclose period-end period-end used 12. for discontinued PE composites: final realization or liquidation liquidation date must be stated 13. funding status: cumulative paid-in-capital paid-in-capital (including paid-in but not yet yet invested), total current invested capital, cumulative distributions paid out to investors in cash or stock, TVPI, DPI, PIC, RVPI 14. recommended: disclose average holding holding period of investments over life life Verifi Verificat cation ion:: review review of perform performance ance measu measurem rement ent polici policies, es, proces processes ses,, and procedu procedures res by an indep independe endent nt third-party for purposes of establishing that a firm claiming compliance has adhered to the GIPS standard a. Scope Scope and and Purpo Purpose se of Verifi Verificati cation: on: i. Verificati Verification on can only be be as to whole whole firm; firm; may have a detaile detailed d Performance Performance Examinat Examination ion conducted on a composite thereafter  ii. Minimu Minimum m verifi verificat cation ion perio period d is one year  year  iii. Verificati Verification on report must must confirm confirm that firm firm has complied complied w/ all composite composite construct construction ion requirements of GIPS on firmwide basis and that firm’s processes and procedures are designed to calculate and present performance results in compliance w/ GIPS iv. Must Must have have report report to to claim claim verifi verificat cation ion v. If not fully compliant compliant,, verifier verifier must provide provide report to firm firm stating why cannot cannot issue verifica verification tion report vi. Minimum Minimum knowledge knowledge-based -based qualificati qualifications ons for for verifi verifiers ers  b. Requir Required ed Veri Verific ficati ation on Proce Procedur dures es 40963581.doc 111 of 114

i. Learn about firm, firm, firm’s firm’s performanceperformance-relat related ed policies policies and valuation valuation basis for performanc performancee calculations ii. Obtain Obtain selected selected samples of investm investment ent performanc performancee reports and and other available available info info iii. Determine Determine firm’s firm’s assumption assumptions, s, policies policies and procedures procedures for establishin establishing g and maintaining maintaining compliance including: 1. written written def of investm investment ent discreti discretion on and guidel guidelines ines therefo therefor  r  2. list of of composite composite definit definitions ions w/ writt written en criterion criterion for includi including ng account w/i w/i 3. policy policy regarding regarding timefra timeframe me for includin including g new accounts accounts in and excluding excluding closed closed accounts from composite 4. policies policies re input input data: data: dividend dividend and interest interest income income accruals accruals and market market valuati valuations, ons,  portfolio and composite return calculation methodologies including assumptions on timing of CFs, presentation of composite returns 5. info on use use of leverage leverage and derivativ derivatives, es, investment investmentss in securitie securitiess or countries countries not included in composite’s benchmark, timing of implied taxes on income and realized cap gains if firm reports on after-tax basis 6. “any other other policies policies and and procedures procedures relevant relevant to performa performance nce presentati presentation” on” iv. iv. Stuf Stufff to to gat gathe her: r: 1. sample sample performan performance ce presenta presentations tions and marketi marketing ng material materialss 2. all of firm’s firm’s performan performance-rel ce-related ated policies, policies, such such as firm’s firm’s definition definition of discret discretion, ion, the sources, methods, and review procedures for asset valuations, the time-weighted rateof-return calculation methodology, the treatment of external cash flows, the computation of composite returns, etc. 3. comple complete te list list and descri descripti ption on of compos composit ites es 4. composite composite definitio definitions, ns, including including benchmarks benchmarks and written written criteri criteriaa for including including accounts accounts 5. list list of all all portf portfoli olios os under under manage managemen mentt 6. all investmen investmentt management management agreements agreements or contracts contracts,, and clients’ clients’ investment investment guideline guideliness 7. list of all all portfolios portfolios that that have been in each composite composite during during the verificat verification ion period, period, the dates they were in the composites, and documentation supporting any changes to the  portfolios in the composites. 8. sample sample historical historical portfo portfoliolio- and and composite composite-level -level performance performance data data v. Dete Determ rmin inat atio ions ns:: 1. determine determine has been and remain remainss appropri appropriately ately defined defined 2. determine determine defined defined and maintai maintained ned composites composites consist consistently ently in in compliance compliance 3. determ determine ine bench benchmar marks ks are are approp appropria riate te 4. determ determine ine list list of comp composi osites tes is is comple complete te 5. determine determine that all all actual discret discretionar ionary y fee-paying fee-paying portfolios portfolios are are included included in at least one composite, and that all accounts are included in their respective composites at all times, and that none belonging is excluded 6. determine determine def def of discretion discretion has been been consisten consistently tly applie applied d 7. determine determine accounts accounts consistent consistently ly apply discret discretionar ionary y and non-discret non-discretionar ionary y 8. obtain obtain complete complete list of open and closed closed accounts; accounts; select select appropri appropriate ate sample sample 9. confirm confirm timing timing of inclusion inclusion and and shifting shifting of accounts accounts conforms conforms to to definition definition 10. recalculate sample of returns and dispersion dispersion measures and determine computations conform 11. review sample of composite presentations for compliance vi. must mainta maintain in sufficie sufficient nt info to to support support verificat verification ion report report vii. firm must must provide provide representati representation on letter to to verifiers verifiers of major major policies policies and other reps reps c. Detailed Detailed Examina Examinations tions of Invest Investment ment Performance Performance Presentati Presentations ons Appendix A: Sample GIPS-Compliant Presentations Appendix B: Sample List and Description of Composites 40963581.doc 112 of 114

Appendix C: GIPS Advertising Guidelines 1. mandat mandatory ory if clai claim m GIPS GIPS comp complia liance nce 2. any written written or electronic electronic materials materials addressed addressed to more than one prospecti prospective ve or existing existing client (excludes (excludes one-onone advertisements!) 3. all advertisem advertisements ents that claim claim compliance compliance must include include descript description ion of firm firm and info about how how to obtain list list and description of all firm’s composites or a presentation that complies w/ GIPS 4. “[Name “[Name of firm] firm] claims complianc compliancee w/ the Global Investm Investment ent Performanc Performancee Standards Standards (GIPS®).” (GIPS®).” 5. if further further present present performance, performance, must describe describe strategy strategy of advertise advertised d composite, composite, indicate indicate gross or net of fees, currency. Must present present period-to-date period-to-date composite results. Less than than year returns cannot be annualized. Must  present 1, 3, and 5, or just 5 year composite returns, and indicate end-of-period; present compliant benchmark  total return for same periods and described, if none, non e, disclose why; disclose material leverage and derivatives 6. if presentin presenting g noncompliant noncompliant info, info, must must disclose disclose such, reasons reasons and and periods periods of such 7. supple supplemen mental tal info info must must not be more more promi prominent nent Appendix D: Private Equity Valuation Principles Appendix E: GIPS Glossary •

Other issues: i. After-Tax After-Tax Return Return Calcula Calculation tion Methodolog Methodology: y: not required required by GIPS GIPS ii. Guidance Guidance Statemen Statementt for Country-Spe Country-Specifi cificc Taxation Taxation Issues Issues Preliquidation return: 1. Consis Consisten tentt use of “ant “antici icipat pated ed tax rates rates”” i. Anticipated Anticipated income income tax tax rate = Federal Federal tax rate rate + [State [State tax rate rate x (1 –  Federal tax rate)] + [Local tax rate x (1 – Federal tax rate)] ii. if client’s client’s tax rate rate unknown, unknown, then may use maximum maximum federal federal tax rate rate for  specific category of investor etc. 2. “rea “reali lize zed d tax taxes es”: ”: T real  = (G Lreal  ×T  Lcgr  ) + ( GSreal  ×T Scgr  ) + ( INC  tA ×T incr  ) MV 1 − MV 0 − CF  − T real  3. Preli Preliqui quidat dation ion afterafter-tax tax Modif Modified ied Dietz: Dietz: r  PLATModDie tz  = ( CF i × wi ) MV 0 + •

∑

4. Afte Afterr-ta tax x LIRR LIRR:: MV 1 − T real  =

•

∑ CF i × (1 + r )

wi

+ MV 0 (1 + r )

5. Preliquidat Preliquidation ion after-t after-tax ax return return with with daily daily valuations: valuations: MV  ED − MV  BD − T real  r  PLATdv = ; can then be chain-linked MV  BD 6. Pre-tax Pre-tax returns returns for composit composites es that hold hold tax-exempt tax-exempt securiti securities es must not not be grossed up for taxes. 7. Full Full credi creditt for for net net reali realized zed loss losses es mark-to-liquidation return: use liquidation value in both numerator and denominator  1. may provide provide supplemen supplemental tal info info regarding regarding tax effects effects from from nondiscret nondiscretionary ionary:: adds back  G real  + Gunreal  2. gain ra ratio: GR = MV 1 + CF  NetOut  3. Adju Adjust stme ment nt fact factor or::  F  = CF  NetOut  ×T cgr  ×GR 4. Tcgr  = should be weighted average of short-term and long-term cg 5. Modified Modified Dietz Dietz aftertax aftertax return return calculation calculation w/ adjustment adjustment factor factor (removes (removes effect effect of nondiscretionary realized taxes): MV 1 − MV 0 − CF  − T real  +  F  r  AdjPLATMod  Dietz  = ( CF i × wi ) MV 0 +

∑

6. tax loss harvesting: harvesting: recomm recommended ended to disclose disclose % benefit benefit of of tax-loss tax-loss harvesti harvesting ng for composite if realized losses are greater than realized gains during period 40963581.doc 113 of 114

i. Benefi Benefitt of tax loss loss harve harvesti sting: ng:  B = Lnet  ×T cgr  ii. Percen Percentt benefit benefit of of tax loss loss harv harvest esting ing =

•

 B ( MV 0 + MV 1 ) 2

Objectives of GIPS: i. To obtain obtain worldwide worldwide acceptance acceptance of a common common standard standard for calcul calculating ating and presenti presenting ng investment performance ii. To ensure ensure accurate accurate and and consist consistent ent performanc performancee data iii. To promote promote fair, fair, global global competi competition tion for for all all markets markets iv. To foster foster the notion notion of indust industry ry self-r self-regulat egulation ion

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