Portfolio Management in Practice, Volume 1

CFA Institute is the global association of investment professionals that sets the standard for professional excellence and credentials. The organization is a champion for ethical behavior in investment markets and a respected source of knowledge in the global financial community. The end goal: to create an environment where investors’ interests come first, markets function at their best, and economies grow. CFA Institute has more than 155,000 members in 165 countries and territories, including 150,000 CFA® charterholders, and 148 member societies. For more information, visit www.cfainstitute.org.

• Preface xxiAcknowledgments xxiiiAbout the CFA Institute Investment Series xxvChapter 1 Professionalism in the Investment Industry 1Learning Outcomes 11. Introduction 12. Professions 22.1. How Professions Establish Trust 22.2. Professions Are Evolving 43. Professionalism in Investment Management 53.1. Trust in the Investment Industry 63.2. CFA Institute as an Investment Professional Body 64. Expectations of Investment Professionals 75. Framework for Ethical Decision-Making 95.1. Description of the Framework 96. Challenges for Investment Professionals 117. Summary 12References 13Practice Problems 13Chapter 2 Fintech in Investment Management 15Learning Outcomes 151. Introduction 152. What is Fintech? 163. Big Data 173.1. Sources of Big Data 183.2. Big Data Challenges 204. Advanced Analytical Tools: Artificial Intelligence and Machine Learning 204.1. Types of Machine Learning 225. Data Science: Extracting Information from Big Data 235.1. Data Processing Methods 235.2. Data Visualization 246. Selected Applications of Fintech to Investment Management 256.1. Text Analytics and Natural Language Processing 266.2. Robo-Advisory Services 276.3. Risk Analysis 296.4. Algorithmic Trading 307. Distributed Ledger Technology 307.1. Permissioned and Permissionless Networks 327.2. Applications of Distributed Ledger Technology to Investment Management 32Summary 34Practice Problems 35Chapter 3 Capital Market Expectations, Part 1: Framework and Macro Considerations 37Learning Outcomes 371. Introduction 382. Framework and Challenges 382.1. A Framework for Developing Capital Market Expectations 392.2. Challenges in Forecasting 423. Economic and Market Analysis 503.1. The Role of Economic Analysis 513.2. Analysis of Economic Growth 513.3. Approaches to Economic Forecasting 573.4. Business Cycle Analysis 613.5. Analysis of Monetary and Fiscal Policy 683.6. International Interactions 774. Summary 81References 85Practice Problems 85Chapter 4 Capital Market Expectations, Part 2: Forecasting Asset Class Returns 93Learning Outcomes 931. Introduction 942. Overview of Tools and Approaches 942.1. The Nature of the Problem 942.2. Approaches to Forecasting 953. Forecasting Fixed-Income Returns 963.1. Applying DCF to Fixed Income 963.2. The Building Block Approach to Fixed-Income Returns 983.3. Risks in Emerging Market Bonds 1044. Forecasting Equity Returns 1074.1. Historical Statistics Approach to Equity Returns 1074.2. DCF Approach to Equity Returns 1074.3. Risk Premium Approaches to Equity Returns 1114.4. Risks in Emerging Market Equities 1155. Forecasting Real Estate Returns 1175.1. Historical Real Estate Returns 1175.2. Real Estate Cycles 1175.3. Capitalization Rates 1185.4. The Risk Premium Perspective on Real Estate Expected Return 1205.5. Real Estate in Equilibrium 1205.6. Public vs. Private Real Estate 1215.7. Long-Term Housing Returns 1226. Forecasting Exchange Rates 1246.1. Focus on Goods and Services, Trade, and the Current Account 1256.2. Focus on Capital Flows 1277. Forecasting Volatility 1327.1. Estimating a Constant VCV Matrix with Sample Statistics 1327.2. VCV Matrices from Multi-Factor Models 1337.3. Shrinkage Estimation of VCV Matrices 1347.4. Estimating Volatility from Smoothed Returns 1357.5. Time-Varying Volatility: ARCH Models 1368. Adjusting a Global Portfolio 1378.1. Macro-Based Recommendations 1388.2. Quantifying the Views 140Summary 141References 143Practice Problems 145Chapter 5 Overview of Asset Allocation 155Learning Outcomes 1551. Introduction 1552. Asset Allocation: Importance in Investment Management 1573. The Investment Governance Background to Asset Allocation 1583.1. Governance Structures 1583.2. Articulating Investment Objectives 1593.3. Allocation of Rights and Responsibilities 1603.4. Investment Policy Statement 1623.5. Asset Allocation and Rebalancing Policy 1623.6. Reporting Framework 1633.7. The Governance Audit 1634. The Economic Balance Sheet and Asset Allocation 1655. Approaches to Asset Allocation 1695.1. Relevant Objectives 1715.2. Relevant Risk Concepts 1725.3. Modeling Asset Class Risk 1736. Strategic Asset Allocation 1806.1. Asset Only 1826.2. Liability Relative 1886.3. Goals Based 1917. Implementation Choices 1957.1. Passive/Active Management of Asset Class Weights 1967.2. Passive/Active Management of Allocations to Asset Classes 1967.3. Risk Budgeting Perspectives in Asset Allocation and Implementation 2008. Rebalancing: Strategic Considerations 2018.1. A Framework for Rebalancing 2038.2. Strategic Considerations in Rebalancing 2049. Summary 206References 207Practice Problems 209Chapter 6 Principles of Asset Allocation 211Learning Outcomes 2111. Introduction 2122. Developing Asset Only Asset Allocations 2132.1. Mean–Variance Optimization: Overview 2132.2. Monte Carlo Simulation 2252.3. Criticisms of Mean–Variance Optimization 2282.4. Addressing the Criticisms of Mean–Variance Optimization 2302.5. Allocating to Less Liquid Asset Classes 2412.6. Risk Budgeting 2432.7. Factor-Based Asset Allocation 2463.1. Characterizing the Liabilities 2503.2. Approaches to Liability-Relative Asset Allocation 2533.3. Examining the Robustness of Asset Allocation Alternatives 2643.4. Factor Modeling in Liability-Relative Approaches 2664. Developing Goals-Based Asset Allocations 2664.1. The Goals-Based Asset Allocation Process 2684.2. Describing Client Goals 2704.3. Constructing Sub-Portfolios 2724.4. The Overall Portfolio 2764.5. Revisiting the Module Process in Detail 2774.6. Periodically Revisiting the Overall Asset Allocation 2814.7. Issues Related to Goals-Based Asset Allocation 2815. Heuristics and Other Approaches to Asset Allocation 2835.1. The “120 minus your age” rule. 2835.2. The 60/40 stock/bond heuristic. 2845.3. The endowment model. 2855.4. Risk parity. 2865.5. The 1/N rule. 2886. Portfolio Rebalancing in Practice 2887. Conclusions 292References 294Practice Problems 296Chapter 7 Asset Allocation with Real-World Constraints 307Learning Outcomes 3071. Introduction 3072. Constraints in Asset Allocation 3082.1. Asset Size 3082.2. Liquidity 3142.3. Time Horizon 3172.4. Regulatory and Other External Constraints 3213. Asset Allocation for the Taxable Investor 3273.1. After-Tax Portfolio Optimization 3213.2. Taxes and Portfolio Rebalancing 3313.3. Strategies to Reduce Tax Impact 3324. Revising the Strategic Asset Allocation 3374.1. Goals 3375. Short-Term Shifts in Asset Allocation 3435.1. Discretionary TAA 3445.2. Systematic TAA 3456. Dealing with Behavioral Biases in Asset Allocation 3496.1. Loss Aversion 3496.2. Illusion of Control 3506.3. Mental Accounting 3516.4. Representativeness Bias 3526.5. Framing Bias 3526.6. Availability Bias 3547. Summary 357References 359Practice Problems 360Chapter 8 Currency Management: An Introduction 369Learning Outcomes 3691. Introduction 3692. Review of Foreign Exchange Concepts 3702.1. Spot Markets 3712.2. Forward Markets 3732.3. FX Swap Markets 3762.4. Currency Options 3773. Currency Risk and Portfolio Return and Risk 3773.1. Return Decomposition 3783.2. Volatility Decomposition 3804. Currency Management: Strategic Decisions 3834.1. The Investment Policy Statement 3844.2. The Portfolio Optimization Problem 3854.3. Choice of Currency Exposures 3864.4. Locating the Portfolio Along the Currency Risk Spectrum 3894.5. Formulating a Client-Appropriate Currency Management Program 3935. Currency Management: Tactical Decisions 3955.1. Active Currency Management Based on Economic Fundamentals 3965.2. Active Currency Management Based on Technical Analysis 3975.3. Active Currency Management Based on the Carry Trade 3995.4. Active Currency Management Based on Volatility Trading 4016. Tools of Currency Management 4066.1. Forward Contracts 4076.2. Currency Options 4146.3. Strategies to Reduce Hedging Costs and Modify a Portfolio’s Risk Profile 4166.4. Hedging Multiple Foreign Currencies 4246.5. Basic Intuitions for Using Currency Management Tools 4317. Currency Management for Emerging Market Currencies 4357.1. Special Considerations in Managing Emerging Market Currency Exposures 4357.2. Non-Deliverable Forwards 4378. Summary 438References 441Practice Problems 441Chapter 9 Overview of Fixed-Income Portfolio Management 453Learning Outcomes 4531. Introduction 4532. Roles of Fixed-Income Securities in Portfolios 4542.1. Diversification Benefits 4542.2. Benefits of Regular Cash Flows 4562.3. Inflation Hedging Potential 4573. Fixed-Income Mandates 4593.1. Liability-Based Mandates 4603.2. Total Return Mandates 4644. Bond Market Liquidity 4684.1. Liquidity among Bond Market Sub-Sectors 4684.2. The Effects of Liquidity on Fixed-Income Portfolio Management 4695. A Model for Fixed-Income Returns 4715.1. Decomposing Expected Returns 4715.2. Estimation of the Inputs 4755.3. Limitations of the Expected Return Decomposition 4756. Leverage 4766.1. Using Leverage 4776.2. Methods for Leveraging Fixed-Income Portfolios 4776.3. Risks of Leverage 4817. Fixed-Income Portfolio Taxation 4817.1. Principles of Fixed-Income Taxation 4827.2. Investment Vehicles and Taxes 4838. Summary 484References 486Practice Problems 486Chapter 10 Liability-Driven and Index-Based Strategies 493Learning Outcomes 4931. Introduction 4942. Liability-Driven Investing 4953. Interest Rate Immunization—Managing the Interest Rate Risk of a Single Liability 4984. Interest Rate Immunization—Managing the Interest Rate Risk of Multiple Liabilities 5114.1. Cash Flow Matching 5114.2. Duration Matching 5144.3. Derivatives Overlay 5204.4. Contingent Immunization 5245. Liability-Driven Investing—An Example of a Defined Benefit Pension Plan 5266. Risks in Liability-Driven Investing 5367. Bond Indexes and the Challenges of Matching a Fixed-Income Portfolio to an Index 5418. Alternative Methods for Establishing Passive Bond Market Exposure 5479. Benchmark Selection 55310. Laddered Bond Portfolios 55611. Summary 559References 563Practice Problems 564Chapter 11 Overview of Equity Portfolio Management 573Learning Outcomes 5731. Introduction 5732. The Roles of Equities in a Portfolio 5742.1. Capital Appreciation 5742.2. Dividend Income 5752.3. Diversification with Other Asset Classes 5762.4. Hedge Against Inflation 5772.5. Client Considerations for Equities in a Portfolio 5773. Equity Investment Universe 5793.1. Segmentation by Size and Style 5793.2. Segmentation by Geography 5813.3. Segmentation by Economic Activity 5833.4. Segmentation of Equity Indexes and Benchmarks 5854. Income and Costs in an Equity Portfolio 5854.1. Dividend Income 5864.2. Securities Lending Income 5864.3. Ancillary Investment Strategies 5874.4. Management Fees 5884.5. Performance Fees 5884.6. Administration Fees 5894.7. Marketing and Distribution Costs 5894.8. Trading Costs 5894.9. Investment Approaches and Effects on Costs 5905. Shareholder Engagement 5905.1. Benefits of Shareholder Engagement 5915.2. Disadvantages of Shareholder Engagement 5925.3. The Role of an Equity Manager in Shareholder Engagement 5926. Equity Investment across the Passive–Active Spectrum 5946.1. Confidence to Outperform 5946.2. Client Preference 5956.3. Suitable Benchmark 5966.4. Client-Specific Mandates 5966.5. Risks/Costs of Active Management 5966.6. Taxes 596Summary 597References 598Practice Problems 598Chapter 12 Passive Equity Investing 601Learning Outcomes 6011. Introduction 6012. Choosing a Benchmark 6032.1. Indexes as a Basis for Investment 6032.2. Considerations When Choosing a Benchmark Index 6042.3. Index Construction Methodologies 6062.4. Factor-Based Strategies 6123. Approaches to Passive Equity Investing 6153.1. Pooled Investments 6153.2. Derivatives-Based Approaches 6193.3. Separately Managed Equity Index-Based Portfolios 6234. Portfolio Construction 6254.1. Full Replication 6254.2. Stratified Sampling 6274.3. Optimization 6284.4. Blended Approach 6295. Tracking Error Management 6305.1. Tracking Error and Excess Return 6305.2. Potential Causes of Tracking Error and Excess Return 6325.3. Controlling Tracking Error 6326. Sources of Return and Risk in Passive Equity Portfolios 6336.1. Attribution Analysis 6336.2. Securities Lending 6356.3. Investor Activism and Engagement by Passive Managers 637Summary 638References 640Practice Problems 641Chapter 13 Active Equity Investing: Strategies 647Learning Outcomes 6471. Introduction 6472. Approaches to Active Management 6482.1. Differences in the Nature of the Information Used 6502.2. Differences in the Focus of the Analysis 6512.3. Difference in Orientation to the Data: Forecasting the Future vs. Analyzing the Past 6522.4. Differences in Portfolio Construction: Judgment vs. Optimization 6523. Types of Active Management Strategies 6543.1. Bottom-Up Strategies 6543.2. Top-Down Strategies 6613.3. Factor-Based Strategies 6643.4. Activist Strategies 6773.5. Other Strategies 6844. Creating a Fundamental Active Investment Strategy 6874.1. The Fundamental Active Investment Process 6874.2. Pitfalls in Fundamental Investing 6905. Creating a Quantitative Active Investment Strategy 6945.1. Creating a Quantitative Investment Process 6945.2. Pitfalls in Quantitative Investment Processes 6986. Equity Investment Style Classification 7016.1. Different Approaches to Style Classification 7026.2. Strengths and Limitations of Style Analysis 7087. Summary 710References 711Practice Problems 712Chapter 14 Hedge Fund Strategies 719Learning Outcomes 7191. Introduction 7192. Classification of Hedge Funds and Strategies 7213. Equity Strategies 7253.1. Long/Short Equity 7253.2. Dedicated Short Selling and Short-Biased 7283.3. Equity Market Neutral 7324. Event-Driven Strategies 7364.1. Merger Arbitrage 7374.2. Distressed Securities 7405. Relative Value Strategies 7445.1. Fixed-Income Arbitrage 7445.2. Convertible Bond Arbitrage 7496. Opportunistic Strategies 7536.1. Global Macro Strategies 7536.2. Managed Futures 7567. Specialist Strategies 7607.1. Volatility Trading 7617.2. Reinsurance/Life Settlements 7658. Multi-Manager Strategies 7678.1. Fund-of-Funds 7688.2. Multi-Strategy Hedge Funds 7709. Analysis of Hedge Fund Strategies 7749.1. Conditional Factor Risk Model 7759.2. Evaluating Equity Hedge Fund Strategies 7799.3. Evaluating Multi-Manager Hedge Fund Strategies 78410. Portfolio Contribution of Hedge Fund Strategies 78710.1. Performance Contribution to a 60/40 Portfolio 78710.2. Risk Metrics 78911. Summary 793References 796Practice Problems 796Chapter 15 Overview of Private Wealth Management 803Learning Outcomes 8031. Introduction 8032. Private Clients versus Institutional Clients 8042.1. Investment Objectives 8042.2. Constraints 8052.3. Other Distinctions 8063. Understanding Private Clients 8073.1. Information Needed in Advising Private Clients 8073.2. Client Goals 8123.3. Private Client Risk Tolerance 8153.4. Technical and Soft Skills for Wealth Managers 8174. Investment Planning 8194.1. Capital Sufficiency Analysis 8194.2. Retirement Planning 8235. Investment Policy Statement 8275.1. Parts of the Investment Policy Statement 8275.2. Sample Investment Policy Statement for a Private Client 8336. Portfolio Construction and Monitoring 8386.1. Portfolio Allocation and Investments for Private Wealth Clients 8386.2. Portfolio Reporting and Review 8426.3. Evaluating the Success of an Investment Program 8457. Ethical and Compliance Considerations in Private Wealth Management 8487.1. Ethical Considerations 8487.2. Compliance Considerations 8498. Private Client Segments 8508.1. Mass Affluent Segment 8518.2. High-Net-Worth Segment 8518.3. Ultra-High-Net-Worth Segment 8518.4. Robo-Advisors 852Summary 853References 854Practice Problems 855Chapter 16 Topics in Private Wealth Management 863Learning Outcomes 8631. Introduction 8642. General Principles of taxation 8662.1. Taxation of the Components of Return 8662.2. The Tax Status of the Account 8692.3. The Jurisdiction That Applies to the Investor 8713. Measuring Tax Efficiency with After-Tax Returns 8783.1. Tax Efficiency of Various Asset Classes and Investment Strategies 8783.2. Calculating After-Tax Returns 8794. Analyzing the Impact of Taxes IN taxable, Tax-Exempt, and Tax-Deferred Accounts 8884.1. Capital Accumulation in Taxable, Tax-Deferred, and Tax-Exempt Accounts 8894.2. Asset Location 8904.3. Decumulation Strategies 8944.4. Tax Considerations in Charitable Giving 8955. Tax Management Strategies 8965.1. Basic Portfolio Tax Management Strategies 8975.2. Application of Tax Management Strategies 8976. Managing Concentrated Positions 9046.1. Risk and Tax Considerations in Managing Concentrated Single-Asset Positions 9046.2. Strategies for Managing Concentrated Positions in Public Equities 9066.3. Strategies for Managing Concentrated Positions in Privately Owned Businesses 9136.4. Strategies for Managing Concentrated Positions in Real Estate 9157. Directing and transferring wealth 9177.1. Objectives of Gift and Estate Planning 9177.2. Gift and Estate Planning Strategies 9217.3. Managing Wealth across Generations 9338. Summary 940References 943Practice Problems 943Chapter 17 Portfolio Management for Institutional Investors 949Learning Outcomes 9491. Introduction 9502. Institutional Investors: Common Characteristics 9512.1. Scale 9512.2. Long-Term Investment Horizon 9522.3. Regulatory Frameworks 9522.4. Governance Framework 9542.5. Principal–Agent Issues 9553. Overview of Investment Policy 9554. Pension Funds 9584.1. Stakeholders 9604.2. Liabilities and Investment Horizon 9624.3. Liquidity Needs 9664.4. External Constraints Affecting Investment 9684.5. Risk Considerations of Private Defined Benefit Pension Plans 9704.6. Investment Objectives 9744.7. Asset Allocation by Pension Plans 9765. Sovereign Wealth Funds 9805.1. Stakeholders 9815.2. Liabilities and Investment Horizons 9825.3. Liquidity Needs 9845.4. External Constraints Affecting Investment 9855.5. Investment Objectives 9865.6. Asset Allocation by Sovereign Wealth Funds 9886. University Endowments and Private Foundations 9896.1. University Endowments—Stakeholders 9916.2. University Endowments—Liabilities and Investment Horizon 9926.3. University Endowments—Liquidity Needs 9936.4. Private Foundations—Stakeholders 9936.5. Private Foundations—Liabilities and Investment Horizon 9946.6. Private Foundations—Liquidity Needs 9966.7. External Constraints Affecting Investment 9976.8. Investment Objectives 9986.9. Asset Allocation 10047. Banks and Insurers 10117.1. Banks—Stakeholders 10127.2. Banks—Liabilities and Investment Horizon 10137.3. Banks—Liquidity Needs 10147.4. Insurers—Stakeholders 10147.5. Insurers—Liabilities and Investment Horizon 10167.6. Insurers—Liquidity Needs 10177.7. External Constraints Affecting Investment 10187.8. Investment Objectives 10207.9. Banks and Insurers—Balance Sheet Management and Investment Considerations 1024Summary 1042References 1044Practice Problems 1045Chapter 18 Trade Strategy and Execution 1053Learning Outcomes 10531. Introduction 10532. Motivations to Trade 10542.1. Profit Seeking 10542.2. Risk Management/Hedging Needs 10562.3. Cash Flow Needs 10572.4. Corporate Actions/Index Reconstitutions/Margin Calls 10583. Trading Strategies and Strategy Selection 10603.1. Trade Strategy Inputs 10603.2. Reference Prices 10653.3. Trade Strategies 10684. Trade Execution (Strategy Implementation) 10744.1. Trade Implementation Choices 10744.2. Algorithmic Trading 10774.3. Comparison of Markets 10835. Trade Evaluation 10875.1. Trade Cost Measurement 10875.2. Evaluating Trade Execution 10956. Trade Governance 11026.1. Meaning of Best Order Execution within the Relevant Regulatory Framework 11036.2. Factors Used to Determine the Optimal Order Execution Approach 11036.3. List of Eligible Brokers and Execution Venues 11056.4. Process Used to Monitor Execution Arrangements 11067. Summary 1108Practice Problems 1110Chapter 19 Portfolio Performance Evaluation 1121Learning Outcomes 11211. Introduction 11222. The Components of Performance Evaluation 11223. Performance Attribution 11243.1. Approaches to Return Attribution 11273.2. Risk Attribution 11443.3. Return Attribution Analysis at Multiple Levels 11464. Benchmarking Investments and Managers 11534.1. Asset-Based Benchmarks 11554.2. Properties of a Valid Benchmark 11574.3. Evaluating Benchmark Quality: Analysis Based on a Decomposition of Portfolio Holdings and Returns 11604.4. Benchmarking Alternative Investments 11624.5. Importance of Choosing the Correct Benchmark 11665. Performance Appraisal 11675.1. Distinguishing Investment Skill from Luck 11675.2. Appraisal Measures 11685.3. Evaluation of Investment Manager Skill 1183Summary 1187References 1188Practice Problems 1189Chapter 20 Investment Manager Selection 1193Learning Outcomes 11931. Introduction 11932. A Framework for Investment Manager Search and Selection 11942.1. Defining the Manager Universe 11962.2. Type I and Type II Errors in Manager Selection 11973. Quantitative Elements of Manager Search and Selection 12003.1. Style Analysis 12003.2. Capture Ratios and Drawdowns in Manager Evaluation 12034. Qualitative Elements of Manager Due Diligence 12074.1. Investment Philosophy 12074.2. Investment Personnel 12114.3. Investment Decision-Making Process 12114.4. Operational Due Diligence 12135. Summary 1226References 1228Practice Problems 1220Glossary 1243About the Authors 1257About the CFA Program 1259Index 1261