PM Level 1

JuiceNotes TM
- By FinTree
eBook 6
Portfolio Management
CFA® Level 1 JuiceNotesTM 2017

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Portfolio Management : An Overview
https://www.fintreeindia.com/ © 2017 FinTree Education Pvt. Ltd.
LOS a Portfolio approach of investing

Portfolio is a basket of securities which helps in reducing risk.
The portfolio perspective refers to evaluating individual investments

by their contribution to the risk and return of an investor’s portfolio.
Modern portfolio theory concludes that the extra risk from holding only a
single security is not rewarded with higher expected investment returns.
Standard deviation is the risk of upward/downward returns.
During financial crisis, correlations tend to increase, which reduces the

benefits of diversification
σ of portfolio
Diversification ratio =
σ of security
LOS b Types of investors Endowment - It is a fund that is dedicated to providing

financial support on an ongoing basis for
è Individual investors a specific purpose
è Institutions
è
è
è
è
Banks
Insurance companies
Investment companies
Sovereign wealth funds e
Foundation - It is a fund established for charitable
purposes to support specific types of
activities or to fund research related to a
particular disease
re
Distinctive characteristics and needs of investors
Investors Risk tolerence Investment Liquidity Income

horizon needs needs
nT
Individuals Depends on Depends on Depends on Depends on

individual individual individual individual
Banks Low Short High Pay
interest
Endowments High Long Low Spending
level
Fi
Insurance Low Life - Long High Low

P&C - Short
Mutual funds Depends on Depends on High Depends on
fund fund fund
Defined High Long Low Depends on
benefit age
pensions
LOS c
Defined contribution Defined benefit
pension plan pension plan
Employer and employee both contribute Only employer contributes to a

an amount to employee’s retirement fund to provide benefits to the
account each period employee
Contribution may be based on years of Benefit is usually based on employee’s

service, employee’s compensation, his age years of service and his compensation
or even a percentage of his contribution near retirement
Firm makes no promise to employee Firm promises to make periodic payments

regarding the future value of plan assets to employee after retirement
The investment decisions are left to the Since employee’s future benefit is defined,
employee who assumes all investment risk employer assumes the investment risk
LOS d
Step 1 Planning
e
Three major steps in portfolio management process
ª Making investment policy statement (IPS)

re
ª Updating IPS every few years and any time when
investor’s objectives or constraints change significantly
Step 2 Execution ª Involves analysis of risk and returns characteristics of

various asset classes to determine how funds will be
allocated to different asset types
ª Top-down analysis - macro analysis
ª bottom-up analysis - micro analysis
nT
Step 3 Feedback ª Portfolio manager must monitor changes such as risk

and return characteristics of asset classes, their
weights, investor’s preferences etc. and rebalance the
portfolio periodically.
ª Manager must also measure portfolio performance and
evaluate it against the benchmark portfolio
Fi
LOS e Types of mutual funds and other pooled investment products
1 Pooled investments ª Single portfolio that contains investment funds from multiple investors
ª Mutual funds are one form of pooled investments.
ª Each investor owns shares representing ownership of a portion of the
overall portfolio
Net value of assets in the fund
ª NAV =
No. of shares
2 Open-end fund Closed-end fund
Investors can buy newly issued These are professionally

shares at NAV managed pools
Investors can sell their shares They do not take new

back to the fund at NAV as well investments into the fund or
redeem investor shares
All MFs charge a fee for
managing the portfolio assets, Shares of a such fund trade like
which is expressed as a equity shares (on exchanges or
percentage of NAV OTC)
No-load funds do not charge additional fees for purchasing shares (up-front fees) or
for redeeming shares (redemption fees)
Load funds charge either up-front fees or redemption fees or both
3 Types of Mutual Funds
Money market funds They invest in short-term debt securities
Bond mutual funds
Stock mutual funds

e
They invest in fixed-income securities
They invest in equity/preferred stocks

re
Index funds These are passively managed funds
Actively managed funds Managers selects individual securities with the goal of
producing returns greater than benchmark indexes
4 Other forms of pooled investments

nT
Exchange-traded funds (ETFs) Ÿ They are similar to Closed-end funds in that purchases and
sales are made in the market rather than with the fund itself
Ÿ They are passively managed
Ÿ Price of the shares can differ significantly from their NAV
because of demand and supply
Ÿ Investors receive any dividend income on portfolio stocks in
cash
Fi
Ÿ ETFs may produce less capital gains liability compared to

open-end index funds
Separately managed account Ÿ It is a portfolio that is owned by a single investor and
managed according to that investor’s needs and preferences
Hedge funds Ÿ These are pools of investor funds that are not as regulated
as mutual funds
Ÿ They are limited in the number of investors
Ÿ Often sold only to qualified investors
Ÿ Minimum investments is quite high ($250k to $1m)
5 Hedge fund strategies
Long/short funds They buy securities that are expected to outperform the market and sell
securities short that are expected to underperform the market
Equity market- These are funds with long stock positions that are just offset in value by
neutral funds stocks sold short. These funds are designed to be neutral with respect to
overall market movements so that they can be profitable in both up and
down markets as long as their longs outperform their shorts.
Equity hedge fund It is a long/short fund dedicated to a larger long position relative to
with a bias short sales (long bias) or to a greater short position relative to long
positions (short bias)
Event-driven funds They invest in response to one-time corporate events. Eg mergers and
acquisitions
Fixed-income They take long and short positions in debt securities, attempting to
arbitrage funds profit from minor mispricings
Convertible bond They take long and short positions in convertible bonds and the equity
arbitrage funds shares they can be converted into in order to profit from a relative
mispricing between the two
Global macro funds They speculate on changes in international interest rates and currency
exchange rates
6 Buyout funds
(Private equity funds) e 7 Venture capital funds
re
Ÿ They buy entire public companies and take Ÿ They are similar to buyout funds, except that
them private. This purchase is often funded the companies they invest in are in their
with a firm’s debt (leveraged buyout). start-up phase.
Ÿ The fund attempts to reorganize the firm to Ÿ Their intention is to grow these start-ups
increase its cash flow, pay its debt, increase into valuable companies so that they can be
nT
the value of its equity, and then sell the sold publicly via an IPO or sold to an
restructured firm or its parts in a public established firm
offering or to another company.
Fi
Risk Management : An Introduction
LOS a Risk management It is process that seeks to

ª Identify the risk tolerance of the organization
ª Identify and measure the risks that the organization faces
ª Modify and monitor these risks
The process does not seek to eliminate all these risks
LOS b Risk management framework

ª Establishing processes and policies for risk governance
ª Determining organization’s risk tolerance
ª Identifying and measuring existing risks
ª Managing and mitigating risks to achieve the optimal bundle of risks
ª Monitoring risk exposures over time
ª Communicating across the organization
LOS c Risk It refers to senior management’s determination of the risk

governance tolerance, the elements of its optimal risk exposure strategy and
the framework for oversight of the risk management function
LOS d Risk Involves setting the overall risk exposure the organization
tolerance
e
will take by identifying the risks the firm can effectively take
When analyzing risk tolerance, management must examine risks that
exist within the organization as well as those that may arise from outside
re
LOS e Risk It is the process of allocating resources to investments by considering their
budgeting various risk characteristics and how they match organization’s risk tolerance
LOS f Financial sources of risk Non-Financial sources of risk

nT
Operational risk - Risk of loss due to human

error or faulty organizational process
Credit risk (default risk) - Risk that Solvency risk - Risk that the organization
counterparty will fail to perform its will be unable to continue to operate
contractual obligations because it has run out of cash
Regulatory risk - Risk that the regulatory
environment will change
Fi
Liquidity risk - risk of loss when selling Political risk - Risk that political actions
an asset at a time when market price is outside a regulatory framework, will impose
less than the fair value of the asset significant costs on an organization
Legal risk - Uncertainty about the
organization’s exposure to future legal action
Tail risk - Risk that are in the tails of the
Market risk - uncertainty about market distribution of outcomes are more likely than
prices of assets and interest rates the organization’s analysis indicates
Accounting risk - Risk that the organization’s
accounting policies and estimates are
incorrect.
2 Mortality risk Risk of death Addressed with life insurance
Longevity risk Risk of living longer Addressed by purchasing

than expected a lifetime annuity
Individuals face mortality and longevity risks, in addition to financial risks
LOS g Measures of risk
Standard deviation It is a measure of the volatility of asset prices and interest rates
Not appropriate measure of risk for non-normal distributions, especially

those with negative skew or positive excess kurtosis.
Beta Measures the market risk of equity securities and portfolios of

equity securities
Appropriate for securities held in a well-diversified portfolio
Duration It is a measure of the price sensitivity of debt securities to

changes in interest rates
Derivatives risks (The Greeks)
e
ª Delta - Sensitivity of derivatives values to the price of the underlying asset
ª Gamma - Sensitivity of delta to changes in the price of the underlying asset

re
ª Vega - Sensitivity of derivatives values to the volatility of price of the underlying asset
ª Rho - Sensitivity of derivatives values to changes in the risk-free rate
Tail risk ª Also known as downside risk

ª Risk of probability of extreme negative outcomes
nT
ª Commonly used measures of tail risk - VaR, Conditional VaR
ª It is the minimum loss over a period that will occur with a

Value at risk (VaR)
specific probability
ª It is the minimum loss that will occur
ª VaR does not provide a maximum loss for a period
ª One-week VaR of $1mln with probability of 5% means one-
week loss of at least $1mln is expected to occur 5% of the
Fi
time
Conditional VaR ª It is the expected value of a loss, given that the loss
exceeds a minimum amount
ª It is calculated as arithmetic average of probability losses in
the tail
VaR CVaR
Risk assessment
methods
Stress Scenario
testing analysis
Examines the effects of a Refers to a what-if analysis

specific change in a key of expected loss but
variable such as an interest incorporates changes in
rate or exchange rate multiple inputs
Risk transfer Another party takes on the risk

Eg. Insurance
Risk shifting It is a way to change the distribution of possible outcomes and is

accomplished with derivative contracts.
Eg. Forward currency contracts
Surety bond
Fidelity bond e
Insurance company agrees to pay if a third party fails to
perform under the terms of contract
Insurance company agrees to pay for losses that result from

re
employee theft or misconduct
nT
Fi
Portfolio Risk And Return : Part I
LOS a Major return measures
Holding period Arithmetic mean Geometric mean Money-weighted

return return return rate of return
Eg. Return on Eg. Return on stock for

Eg. Stock price for
stock for 3 years 3 years Eg.
4 weeks
CF0 CF1 CF2
18%, −4%, 19% 18%, −4%, 19% -48 -65 144
72, 65, 76, 83
CPT IRR
AM = GM =
HPR = 83/72 - 1 3
18-4+19/3 √1.18+0.96+1.19 − 1 MWRR = 18.26%
= 15.27%
= 11% = 10.46%
Other return measures
Gross return It is the total return on a security portfolio before deducting fees
for the management and administration.
Net return
e
It is the return after deduction of management and administration
fees.
Commissions and other costs that are necessary to generate the investment returns are
re
deducted in both gross and net return.
Pretax nominal It is return prior to paying taxes

return
After-tax It is return after paying taxes
nominal return
nT
Real return It is nominal return adjusted for inflation

Real return(approx.) = Nominal return - Inflation
leveraged It is calculated as the gain or loss on the investment as a

return percentage of investor’s cash investment
Leveraged investments in real estate are very common
Fi
LOS b Small-capitalization stocks have had the greatest average returns

and greatest risk over the period.
T-bills had the lowest average returns and the lowest standard
deviation of returns.
LOS c Population variance Sample variance
∑ (x − μ)2 ∑ (x − x)2
n n-1
Covariance Correlation
µ It is a measure of how two assets move µ Standardized measure of covariance
together
µ Measures strength of linear relationship
µ Covariance of return with itself is its between two random variables
variance
µ Does not have a unit
µ Expressed in terms of square units
µ r = Cov(x,y)
µ Cov(x,y) = ∑ (X − X) (Y − Y) σx x σy
n
µ Range = −1 to +1
µ Cov(x,y) = r x σx x σy
µ r = 1 means perfectly +ve relation
µ Range = −∞ to +∞ µ r = 0 means no relation
e µ r = −1 means perfectly −ve relation

re
LOS d Risk aversion and its implications for portfolio selection
Risk-averse Risk-neutral Risk-seeking/loving

investor investor investor
nT
An investor that simply Such investor has no An investor that prefers

dislikes risk preference regarding risk more risk to less
Given two He would be indifferent Given two

investments that have between two such investments that have
equal expected returns, investments equal expected returns,
Fi
a risk-averse investor a risk-loving investor

will choose the one will choose the one
with less risk with more risk
a risk averse investor will hold very risky assets if he feels that the extra
return he expects to earn is adequate compensation for the additional risk
LOS e Portfolio standard deviation
√(W1σ1)2 + (W2σ2)2 + 2W1σ1W2σ2 x r Or √(W1σ1)2 + (W2σ2)2 + 2W1W2 x Cov(x,y)

LOS f Portfolio risk when r = -1, 0, 1
When r = −1, When r = 0, When r = 1,

Sdp = (W1σ1) − (W2σ2) Sdp= √(W1σ1)2 + (W2σ2)2 Sdp = (W1σ1) + (W2σ2)
Sdp = Lowest Sdp = Highest
Portfolio risk falls as the correlation between the assets’ returns decreases.
As long as r < 1, there is some benefit of diversification
LOS g
E(R) E(R) E(R)
} Inefficient
portfolios
σ σ σ
Minimum Global minimum
Efficient frontier
variance frontier variance portfolio
Each point on MVF shows lowest

risk (variance/standard e
Each point on EF shows lowest
risk (variance/standard
The portfolio on the efficient
frontier that has the least risk is
re
deviation) for given level of deviation) for given level of the global minimum-variance
returns returns portfolio
Each point on EF shows highest
returns for given level of risk
(variance/standard deviation)
nT
LOS h Optimal portfolio, given an investor’s utility and the capital allocation line
E(R) E(R) E(R)
Id3 Id2 Id1 Id3 Id2 Id1

Capital
Allocation Line CAL
Fi
X
RFR
σ σ σ
An investor will always choose the Possible combinations of risk-free X is the optimal portfolio i.e.
highest indifference curve (Id3) assets and risky assets is referred one that maximizes the
to as the capital allocation line investor’s expected utility
More risk-averse investor will have steeper indifference curves,

reflecting a higher risk aversion coefficient
Portfolio Risk And Return : Part II
LOS a Implications of combining a risk-free

asset with a portfolio of risky assets
For risk-free assets Standard deviation (σ) = 0

Correlation (r) with risky assets = 0
σp with risky asset σp = W1σ1
and risk-free asset
LOS b Capital allocation line and capital market line
E(R) E(R)
Capital Capital
CML is same as CAL except
Allocation Line Market Line
that CML assumes
homogeneous expectations Efficient
frontier
of investors (i.e. investors
X
have same estimates of risk,
return, and correlations with RFR RFR
other risky assets)
σ σ
E(R) for CAL E(R) = RFR + Sharpe ratio of risky asset X σp

e X - Optimal risky portfolio or
Market portfolio
Lending portfolio
Borrowing portfolio
re
E(R) for CML E(R) = RFR + Sharpe ratio of market X σp
LOS c
Systematic risk Unsystematic risk
nT
ª The risk that remains and cannot be

diversified away is called systematic ª The risk that is eliminated by
risk diversification is called unsystematic
risk
ª Arises due to changes in economy
ª Also called as unique, diversifiable or
ª Also called as nondiversifiable risk firm specific risk
or market risk
ª Unsystematic risk is not compensated
ª Firms that are highly correlated in equilibrium because it can be
with market returns have high eliminated for free through
Fi
systematic risk diversification
ª It is measured by beta (β)
The required return on an individual security will depend only on its systematic risk
Total risk = Systematic risk + Unsystematic risk
LOS d Return generating models
A return generating model is an equation that estimates the

expected return of an investment, based on a security’s exposure to
one or more macroeconomic, fundamental, or statistical factors
Multifactor model - E(R) = RFR + E(Factor 1) β1 + E(Factor 2) β2 + .... + E(Factor k) βk
Single-factor model - E(R) = RFR + (Rm – RFR) x β
LOS e Covariance (x,y) r x σx x σy σ

Beta = = 2 = r σ
x
Variance (y) σ y y
In practice, asset betas are estimated by regressing returns on the asset on those of the market index
Excess
return on
stock
Regression
line
Regression line is referred to as
Security characteristic line
Slope = Cov (x,y)
σy2
RFR
e
Excess
return on
market
re
LOS f, g Security Market Line (SML) and
Capital Asset Pricing Model (CAPM)
SML is same as CML except E(R) This relation between beta

that SML has beta (β) on x-axis Security (systematic risk) and expected
Market Line return is known as CAPM
SML is used for security
nT
selection E(R) for SML

Market portfolio
Kce = RFR + (Rm - RFR) x β
(CAPM)
RFR
Assumptions Investors are Investor that dislikes risk.

Fi
of CAPM risk averse

Utility maximizing Investors choose the portfolio, based on their individual preferences,
investors with the risk and return combination that maximizes their utility
Frictionless markets No taxes, transaction costs etc.
One-period horizon All investors have same time horizon
Homogeneous All investors have same expectations for assets’ expected
expectations returns, their standard deviation and correlations between them
Divisible assets All investments are infinitely divisible
Competitive markets Investors take the market price as given and no investor can influence
prices with their trades
Excess return
E(R) Impossible
on stock
Undervalued
portfolio
Possible Correctly valued

portfolios
RFR
Overvalued
RFR
Excess return
σ on market
Capital Market Line Security Market Line
LOS h Measures of risk adjusted returns
2
Sharpe ratio Treynor ratio Jensen’s Alpha M ratio
Systematic risk Total risk
Total risk Systematic risk (Beta) (Standard deviation)
(Standard deviation) (Beta)
Actual return Sharpe ratio of
Rp - RFR Rp - RFR (Expected return) - portfolio x σm -
σ β Required return Market Risk
(CAPM) Premium
e
Sharpe ratio & M2 ratio produce same rankings
If M2 ratio > 0, then Sharpe ratiop > Sharpe ratiom
If M2 ratio < 0, then Sharpe ratiop < Sharpe ratiom
re
nT
Fi
Basics of Portfolio Planning and Construction
LOS a Reasons for a written IPS
To understand the client’s needs, circumstances, and constraints

It should be standard procedure for a portfolio manager
In some countries, IPS is a legally required
LOS b Major components of IPS
Ê Description of client - Circumstances, situation, and investment objectives

Ê Statement of the Purpose of the IPS
Ê Statement of Duties and Responsibilities - Of investment manager, client and custodian of assets
Ê Procedures to update the IPS and to respond to various contingencies
Ê Investment Objectives - Risk and Return
Ê Investment Constraints - Liquidity, time horizon etc.
Ê Investment Guidelines - How the policy will be executed
Ê Evaluation of Performance - Against benchmark portfolio
Ê Appendices - (A) Strategic Asset Allocation (B) Rebalancing Policy
LOS c
Absolute
Risk objectives
Relative e Return objectives
Absolute Relative
re
Eg. No decrease Eg. Returns will
Eg. Overall Eg. Returns
in portfolio not be less than
return of at should exceed
value during 12 month LIBOR
least S&P 500 Index
any 12-month over any 12
12% p.a. by 2% p.a.
period month period
nT
LOS d
Willingness to take risk Ability to take risk
ª Based on investor’s attitude and

beliefs about investments
Fi
ª Depends on investor’s financial

circumstances
ª Assessment of an investor is
done with short questionnaire ª Secure job, insurances, more
that attempts at knowing wealth suggests greater ability
investor’s risk aversion or risk to take risk
tolerance
An investment advisor must give preference to the lower

of the investor’s ability or willingness to take risk
LOS e Describe investment constraints
Time horizon Longer time horizon - More risk

Shorter time horizon - Less risk
Tax situation Investment advisor should look at the client’s tax treatment of various
types of investments.
Liquidity Refers to the ability to turn investments into cash in a short period of
time without losing significant value of the investment
Investor’s need for cash at different points in time must be considered.
If the investor needs cash immediately, he must be advised to invest
in liquid securities
Legal In addition to financial market regulations, more specific legal and

regulatory constraints may apply to particular investors that might
prohibit them to invest in particular types of securities
Unique circumstances Individuals or institutions may have specific preferences or restrictions

on investing in certain securities. Eg. Ethical preferences, religious
preferences, no investment in competitor’s company etc.
LOS f, g Strategic asset allocation Tactical asset allocation
Specifies the percentage allocations to

the included asset classes
While choosing asset classes, e When strategic asset allocation

weights are varied in order to take
re
correlations of returns within the asset advantage of perceived short-term
class should be high (indicating similar opportunities, it is called tactical
assets in one asset class) and asset allocation
correlations of returns between the
asset classes should be low (low
correlation leads to risk reduction)
nT
Core-satellite It is an approach where majority (core) portion of the portfolio is invested in indexes
approach (passive strategy) and a smaller (satellite) portion in active strategies
This approach reduces the likelihood of excessive trading and offsetting active positions
Fi

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JuiceNotes TM

CFA® Level 1 JuiceNotesTM 2017

FinTree Education Pvt. Ltd. Contact Information

LOS a Portfolio approach of investing

The portfolio perspective refers to evaluating individual investments

Standard deviation is the risk of upward/downward returns.

During ﬁnancial crisis, correlations tend to increase, which reduces the

LOS b Types of investors Endowment - It is a fund that is dedicated to providing

Investors Risk tolerence Investment Liquidity Income

Individuals Depends on Depends on Depends on Depends on

Insurance Low Life - Long High Low

Employer and employee both contribute Only employer contributes to a

Contribution may be based on years of Beneﬁt is usually based on employee’s

Firm makes no promise to employee Firm promises to make periodic payments

ª Making investment policy statement (IPS)

Step 2 Execution ª Involves analysis of risk and returns characteristics of

Step 3 Feedback ª Portfolio manager must monitor changes such as risk

LOS e Types of mutual funds and other pooled investment products

2 Open-end fund Closed-end fund

Investors can buy newly issued These are professionally

Investors can sell their shares They do not take new

Load funds charge either up-front fees or redemption fees or both

3 Types of Mutual Funds

Money market funds They invest in short-term debt securities

Bond mutual funds

Stock mutual funds

They invest in equity/preferred stocks

4 Other forms of pooled investments

Ÿ ETFs may produce less capital gains liability compared to

LOS a Risk management It is process that seeks to

LOS b Risk management framework

LOS c Risk It refers to senior management’s determination of the risk

LOS f Financial sources of risk Non-Financial sources of risk

Operational risk - Risk of loss due to human

2 Mortality risk Risk of death Addressed with life insurance

Longevity risk Risk of living longer Addressed by purchasing

Individuals face mortality and longevity risks, in addition to ﬁnancial risks

LOS g Measures of risk

Not appropriate measure of risk for non-normal distributions, especially

Beta Measures the market risk of equity securities and portfolios of

Appropriate for securities held in a well-diversiﬁed portfolio

Duration It is a measure of the price sensitivity of debt securities to

Derivatives risks (The Greeks)

ª Gamma - Sensitivity of delta to changes in the price of the underlying asset

ª Rho - Sensitivity of derivatives values to changes in the risk-free rate

Tail risk ª Also known as downside risk

ª Commonly used measures of tail risk - VaR, Conditional VaR

ª It is the minimum loss over a period that will occur with a

Examines the effects of a Refers to a what-if analysis

Risk transfer Another party takes on the risk

Risk shifting It is a way to change the distribution of possible outcomes and is

Insurance company agrees to pay for losses that result from

LOS a Major return measures

Holding period Arithmetic mean Geometric mean Money-weighted

Eg. Return on Eg. Return on stock for

Other return measures

Pretax nominal It is return prior to paying taxes

Real return It is nominal return adjusted for inﬂation

leveraged It is calculated as the gain or loss on the investment as a

LOS b Small-capitalization stocks have had the greatest average returns

e µ r = −1 means perfectly −ve relation

Risk-averse Risk-neutral Risk-seeking/loving

An investor that simply Such investor has no An investor that prefers