Modern Portfolio Management

Todd E. Petzel, PhD, is Chief Economist and Co-Chief Investment Officer of Offit Capital, an independent Registered Investment Advisor serving multi-generational wealthy families and not-for-profit organizations. He was previously Chief Investment Officer at Azimuth Trust and Commonfund. He has taught at Macalester College, Stanford University, and the University of Chicago.

• Preface (to come) 1 Introduction 1.1 Why another book on wealth management?1.2 How has thinking evolved?1.3 How did “accepted wisdom” let investors down in 2007-2009?1.4 Make sure the focus of investing portfolios is consistent with the goals of the individual or institution.SECTION A The Foundation of a Modern Portfolio2 Setting Objectives2.1 What are the goals of the investment process?2.2 Sleep-well-at-night money2.3 Long-term growth portfolios2.3.1 The power of compound interest2.3.2 More risk should mean more return2.3.3 Losing 100% is “game over”2.4 Beta – the power of the markets to grow2.5 Stocks versus bonds as a source of beta – what is the beta of hedge funds?2.6 Liquidity and access to the credit markets2.7 Not-for-profits and spending rules3 The Pillars of Portfolio Theory and their Limitations3.1 Risk premiums across assets3.2 The “Free Lunch” of diversification3.3 Owning the “market” is the most risk efficient portfolio3.4 The Efficient Market Hypothesis in its many forms; rational expectations3.5 Modigliani-Miller3.6 Riskless/Costless Market Arbitrage Pricing3.7 Advances in Behavioral Finance4 Building a Modern Portfolio in the Real World; defining your strategy4.1 The Sleep-Well-at-Night portfolio4.1.1 Defining how much is enough.4.1.2 How to preserve wealth and maybe make a little bit along the way4.1.3 The temptation to reach for yield4.2 The Basics of the Growth Portfolio4.2.1 Bonds4.2.2 Stocks4.2.3 Alternative Investments4.2.4 Real Assets4.2.5 Further variation across the investment landscape – currencies, credit, etc.4.3 The Fundamental Liquidity QuestionWhy liquidity matters: your situation changes; the market changes; you simply change your mind; the credit market is not always there when you want it. Giving up liquidity in PE partnerships and hedge funds must be done in terms of alternative opportunities.4.4 Establishing a portfolio mix and a strategy objective4.4.1 Determining the goals for return and risk4.4.2 Broad assumptions about the risk and return of investment options4.4.3 The fallacy of relying on Optimizers4.4.4 The fallacy of relying on Simulators4.4.5 Establishing the Target Growth PortfolioSECTION B Building the Modern Portfolio5 Executing the Plan: The Devil is in the Details5.1 How Much Diversification is Right?5.1.1 Questioning the Efficient Markets Hypothesis? Do you have special information or skills?5.1.2 Can you “own the market?” Do you want to given the tools available?5.1.3 Real Diversification versus owning a bunch of different names5.1.4 Real Diversification versus owning offsetting (and expensive) trades5.2 Active managers versus the Index5.2.1 What is alpha and how can you identify its presence? Sources of alpha5.2.1.1 Better information5.2.1.2 Better processing of information5.2.1.3 More Efficient Execution5.2.2 Beta and the reality of costs5.2.3 Bucketing strategies and managers into narrow categories. What is achieved and at what cost?5.2.4 Passive investing is great IF you want to own the index at that point in time.5.2.5 Smart Beta – a quasi-active strategy5.2.6 Active managers can avoid major pitfalls if they are not benchmark constrained.5.3 Luck versus Skill among active managers5.3.1 Evaluating managers, against benchmarks, against each other5.3.2 Classic performance measures and their limitations5.3.2.1 Compounded returns5.3.2.2 Standard Deviation5.3.2.3 Beta5.3.2.4 Correlation5.3.2.5 Autocorrelation5.3.2.6 Sharpe5.3.2.7 Information Ratio5.3.2.8 Sortino5.3.2.9 Omega Ratio5.3.2.10 Final Comment on the Section5.3.3 IRR Calculations and Multiples of Capital Returned5.3.4 Peer groupings5.3.5 Shaping your own expectation for managers and their role in the portfolio5.4 Portfolio Construction and Market Trading Realities: High Frequency Trading,5.5 Manager Due Diligence and Selection5.5.1 Understanding the investment thesis5.5.2 Determining the sources of returns and risks5.5.3 Alpha versus beta, factor decomposition5.5.4 Do the returns justify the risk?5.5.5 Getting to know the team5.5.6 What is the business model of the manager? Are interests even remotely aligned?5.5.7 Reporting: Results, attribution, risk and position transparency5.5.8 Operational due diligence5.5.8.1 trading and trade allocation5.5.8.2 brokerage relationships and soft dollars5.5.8.3 ISDA relationships and OTC derivatives5.5.8.4 custody5.5.8.5 cash movement5.5.8.6 pricing of securities and the calculation of the NAV5.5.8.7 audits – historical financials for firm and funds5.5.8.8 legal and regulatory5.5.8.8.1 PPM5.5.8.8.2 LP Agreement5.5.8.8.3 ADV II5.5.8.8.4 Articles of Incorporation5.5.8.8.5 Subscription Document5.5.8.9 anti-money laundering5.5.8.10 internal compliance5.5.8.11 technology5.5.8.12 cybersecurity5.5.8.13 disaster recovery5.5.9 Background checks: public and private sources5.5.10 Character and confidence: At the end of the day, do you want to associate with the manager and firm under consideration? Are you completely comfortable trusting them?5.6 Ongoing Manager Evaluation5.6.1 Evaluating returns on a regular basis. Positive and negative “outliers.”5.6.2 Is the manager beating benchmarks? Peers? Your expectations? Is it luck, skill or excess risk taking?5.6.3 Deal breakers – time to terminate5.6.3.1 prolonged deviation from expected return performance. Is the process broken?5.6.3.2 change in investment/risk profile from what was advertised and agreed to5.6.3.3 loss of key people5.6.3.4 radical departure from expected/agreed upon client relationships (liquidity provisions, fees, etc.)5.6.3.5 questionable legal issues5.7 The Issue of Fraud5.7.1 Unfortunately, no amount of due diligence will ever eliminate the chance to be victimized by a fraud.5.7.2 The goal is to have as many safeguards in place as possible so that if fraud occurs, it is detected early when its impact is small.5.7.3 Investors are not compensated with higher returns by assuming fraud risk. The only safety precaution is through diversification.5.8 Funds of Funds versus Direct Investment5.8.1 Advantages:5.8.1.1 Seasoned judgment of FoF PM5.8.1.2 Portfolio diversification in a single product5.8.1.3 Access to resources to do extensive due diligence and portfolio evaluation5.8.1.4 Consolidated reporting5.8.1.5 Possibly improved access to managers5.8.2 Negatives:5.8.2.1 Fees5.8.2.2 Perhaps less than ideal portfolio mix.5.8.2.3 Due diligence does not go away, it just changes focus5.8.2.4 A Cautionary Tale5.9 Rebalancing5.9.1 Across asset classes5.9.2 Among managers5.10 Investment Advisers: Getting help when you need it5.10.1 Different advisory models:5.10.1.1 Brokerage/product driven advisers5.10.1.2 Institutional consultants5.10.1.3 Special case of the Outsourced CIO5.10.1.4 Independent advisers5.10.1.5 Robo advisers5.10.2 The question of discretion5.10.3 Deciding the best option5.10.3.1 Alignment of emotions and objectives5.10.3.2 Costs once again5.10.3.3 Evaluating performance6 Tactics for Enhancing Yield6.1 Market Timing6.2 Volatility, The Ignored Dimension6.2.1 Covered calls6.2.2 Fully collateralized short puts6.3 Tax loss harvesting6.4 More Challenged strategies6.4.1 Extending durations in low interest rate environments6.4.2 Substituting credit risk for bond allocations6.4.3 “Insured” portfolios6.4.4 Portable alpha6.4.5 Leveraging small alphas to reach acceptable returns6.4.6 Writing uncovered options to sell time6.4.7 Blindly buying out-of-the-money options to capture tail events7 Black Swan Portfolio Positions7.1 Tail Risk in an Overall Portfolio7.2 Protective Puts7.3 CDS7.4 Other Macro Tail Bets7.5 The Value of Insurance comes from the Impact on Lifestyle when you don’t have it8 Market Bubbles and CrashesSECTION C The Building Blocks for a Modern Portfolio9 Traditional Portfolio Investments9.1 Cash9.2 Fixed Income9.2.1 Forms of Fixed Income Instruments9.2.2 Duration and credit risks; bond pricing, convexity and spreads9.2.3 Sovereign Debt9.2.4 Agency Debt9.2.5 Municipal Debt9.2.6 Corporate Debt9.2.7 Bank Loans9.2.8 Mortgages9.2.9 Direct Loans9.2.10 Cat Bonds9.2.11 Mutual Funds9.2.12 ETFs and ETNs9.3 Credit9.4 The Curious Case of Negative interest Rates9.5 Currencies9.6 Equities9.6.1 Individual equities9.6.2 Preferred stock9.6.3 Convertible bonds9.6.4 Accessing the Equity Market9.6.4.1 Mutual funds, open and closed end (discussion of tax efficiency)9.6.4.2 ETFs and ETN’s9.6.4.3 Completion funds9.7 Hedge Funds9.7.1 Long/short equity oriented9.7.2 130/30 funds9.7.3 Convertible Arb and other Cap Structure funds9.7.4 Event oriented hedge funds9.7.5 Credit funds9.7.6 Macro9.7.7 Multi-strategy9.7.8 Commodity Trading Advisers9.7.9 Quantitative Trading Strategies9.7.10 Insurance and Litigation Funds9.7.11 Risk Parity Funds9.7.12 Volatility Funds9.7.13 Replication Funds9.7.14 Hedge mutual funds and liquid alternatives9.8 Private Equity Partnerships9.8.1 Venture Capital9.8.2 Growth Equity9.8.3 Buy-out9.8.4 Credit-Equity Hybrid Funds9.8.5 Secondary Funds9.8.6 Co-investment Funds9.9 Real Estate9.9.1 Direct ownership of property; residential and commercial9.9.2 Real estate partnerships9.9.3 Real Estate Investment Trusts (REITs)9.10 Other Real Assets/ Commodities9.10.1 Direct ownership of commodities (usually only precious metals, jewels)9.10.2 Commodity based businesses – metals, energy, farm land, timber.9.10.3 Synthetic ownership of commodities and commodity index funds9.10.4 Esoteric Real Assets; Water Rights9.11 Collectables9.12 The Question of Currencies from a Global Portfolio Perspective once again9.13 Cryptocurrencies10 Derivatives10.1 Futures10.1.1 Original and Variation Margins10.1.2 The Price Basis10.1.3 TheDealer Community10.2 Exchange Traded Options10.2.1 Basics of Calls10.2.2 Simple Call Strategies10.2.2.1 Long at-the-money Calls10.2.2.2 Long out-of-the-money Calls10.2.2.3 Simple Short Calls10.2.2.4 Simple Call Spreads10.2.2.5 Call Calendar Spreads10.2.3  Basics of Puts10.2.3.1 Put Spreads10.2.4 Combinations of Calls and Puts10.2.4.1 Straddles and Strangles10.3 Swaps10.3.1 Interest rate hedging10.3.2 Portable alpha10.4 Swaptions10.5 Credit Default Swaps11 Investment structures and packages11.1 Asset Backed Securities11.2 CDO’s and CLO’s11.3 Insurance wrappers11.4 Annuities11.5 Retail Structured ProductsSECTION D Governance, Regulation, and a Look into the Future12 Investment Decision Making and Governance12.1 The family12.2 Not-for-profit boards and committees12.3 Pension plans12.4 Corporate Investments12.5 Socially Responsible Investing13 Regulation of Investment Activity13.1 Capital Raising13.2 Secondary Markets13.3 Investment Companies13.4 Investment Advisers13.5 Summary14 Looking ahead15 10 LessonsAbbreviationsGlossaryIndex