Knowledge | Skills | Conduct

Portfolio Construction

8 questions

Chapter 7

154

Knowledge | Skills | Conduct

Market Information and Research

• Use of official communications

• Types of research and reports

• Key influences on markets and sectors

Use of Derivatives

• Relationship between securities and derivatives

• Relationship between different forms of fixed income security

Portfolio Risk and Management Strategies

• Portfolio risk

• Mitigating portfolio risk

• Investment allocation

• Management strategies and styles

Evaluation of Portfolio Risk and Return

• Performance measure

Chapter Overview

155

Further Information The Takeover Panel

The Takeover Panel or the Panel on Takeovers and Mergers (the “Panel”) is an independent body, whose main functions are to issue and administer the City Code on Takeovers and Mergers (the “Code”) and to supervise and regulate takeovers and other matters to which the Code applies. Its central objective is to ensure fair treatment for all shareholders in takeover bids.

The Payment Systems Regulator (PSR) is an independent economic regulator. Although a subsidiary of the FCA, it has its own statutory objectives, managing director and board. It is funded by the payments industry and is accountable to the UK Parliament.The PSR’s statutory objectives are summarised as follows:• To ensure that payment systems are operated and developed in a way

that considers and promotes the interests of all the businesses and consumers that use them;

• To promote effective competition in the markets for payment systems and services (between operators, PSPs and infrastructure providers);

• To promote the development of, and innovation in, payment systems, in particular the infrastructure used to operate those systems.

Knowledge | Skills | Conduct

(7.1.1) Economic and financial communications

• News services - E.g. Bloomberg, Reuters, CNBC, Financial Times

• Government resources and statistics- Office for National Statistics (ONS) and the Bank of England

• Broker research and distributor information- E.g. market commentary and analysis from major investment banks

• Regulatory resources where relevant- E.g. communications from the FCA

1. Market Information and Research

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Further InformationTechnical analysisTechnical analysts focus on patterns of price movements, trading signals and various other analytical charting tools to evaluate a security's strength or weakness.Support, or support level, refers to the price level that an asset does not fall below for period of time. An asset's support level is created by buyers entering the market whenever the asset dips to a lower price. In technical analysis, the simple support level can be charted by drawing a line along the lowest lows for the time period being considered.Resistance, or a resistance level, is the price point at which the rise in the price of an asset is halted by the emergence of a growing number of sellers who wish to sell at that price. Resistance levels can be short-lived if new information comes to light that changes the overall market’s attitude toward the asset, or they can be long-lasting.Support and resistance are complementary concepts. Resistance establishes the current price ceiling for the stock, commodity or currency, and support forms the floor. When the price action breaches either support or resistance, it is considered to be a trading opportunity.

Technical analysis – Triangle patternsAscending triangles are a bullish formation that anticipates an upside breakout. Descending triangles are a bearish formation that anticipates a downside breakout. Symmetrical triangles, where price action grows increasingly narrow, may be followed by a breakout to either side, up or down.

Knowledge | Skills | Conduct

(7.1.2) Research and reports

• Fundamental analysis- Use of revenues, earnings, future growth, return on equity, etc. (real data) to assess

an intrinsic value of a company

• Technical analysis- Use of past prices and volumes to assess future activity in the security to construct

charts, e.g. line charts, candlestick charts- Identifying lines of support and resistance

• Fund analysis- Using the objectives of the fund to assess performance- Assessment on a like for like basis

• Fund rating agencies and screening software- Websites offering comparisons

• Broker, distributor and sector specific reports- Give an assessment and forecast for the sector and asset class covered- Ranking and recommendation for each company contained

1. Market Information and Research

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Knowledge | Skills | Conduct

(7.3.4) Futures

Note that in futures contracts nothing is bought (or sold) today. It is the terms and conditions that are fixed today regarding a transaction to be completed in the future.

3. Securities and Derivatives Markets

“I agree to buy one thousand shares in XYZ plc (the underlying asset) from you, in three months, for 500p per share”

“I agree to sell one thousand shares in XYZ plc to you, in three months, for 500p per share”

The Buyer The Seller

Futures Contract

(Long position) (Short position)

Values in FinanceRule of law - ContractsA future/forward is a contract and, once the terms are agreed, the conditions set out are bonding on the parties involved.

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Keeping on TargetA fund manager has a portfolio of FTSE100 equities. What should the fund manager do to hedge their portfolio?A. Go long FTSE 100 FuturesB. Go short FTSE100 FuturesC. Go short FTSE 100 Put optionsD. Go long FTSE 100 Call options

Knowledge | Skills | Conduct

(7.3.4) Futures

• Long position

The long futures position makes money in a rising market but loses money in a falling market.

• Short position

3. Securities and Derivatives Markets

Long Futures Position

XYZ plc share price

Prices Falling

Loss

Prof

it

Prices Rising

500

Profit

Loss

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Further InformationBasic terminology of an option

• Call option – an option that gives the long (holder, buyer) the right, but not the obligation, to buy an underlying asset.

• Put option – an option that gives the long (holder, buyer) the right, but not the obligation, to sell an underlying asset.

• Premium – the term used to describe the price paid for an option.

• Strike price – the price at which the underlying asset may be bought or sold by the long. Also referred to as the exercise price.

Answer to the question on the previous slide = BGo short FTSE 100 Futures – an agreement to sell at a fixed price

Knowledge | Skills | Conduct

(7.3.2) Options

Options are derivative contracts that give the holder the right but not the obligation to buy/sell the underlying asset at an fixed price on or before a set date.

£ pays premium

Confers rights

BuyerHolderLong

Has rights

SellerWriterShort

Has obligations (If the buyer exercises their rights)

3. Securities and Derivatives Markets

Values in FinanceRule of law - ContractsAn option is a contract and, once the terms are agreed, the conditions set out are bonding on the parties involved. However, remember that one of those conditions is to confer rights to the buyer.

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Keeping on TargetAn investor buys a put option on a share, with a strike price of £10. The premium paid was £1.50, and the current market price of the shares is £12.What is the net payoff if the option is exercised now? And what would the net payoff be if the option is exercised when the share price falls to £10, or if the share price falls to £7?

A. £0 £0 £3.00 B. -£1.50 £0 £1.50 C. -£1.50 -£1.50 £1.50 D. £0.50 -£1.50 -£1.50

Knowledge | Skills | Conduct

(7.3.2) Options

Further terminology of options markets• Expiry date – the last day of the option’s life

- European style – an option that may be exercised on its expiry date only- American style – an option that may be exercised at any time during its life up to and

including the expiry date

• At-the-money – the long would be indifferent between exercising or abandoning such an option. For example, a call option whose strike price is the same as the current price of the underlying asset.

• In-the-money – the long would exercise this option. For example, a call option whose strike price is below the current price of the underlying asset and which could therefore be exercised for a profit.

• Out-of-the-money – the long would abandon such an option. For example, a call option whose strike price is above the current price of the underlying asset and so, if exercised, will result in a loss.

3. Securities and Derivatives Markets

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Knowledge | Skills | Conduct

(7.3.2) Options

Trading strategies

• Gaining exposure to an equity (‘speculation’)- Long call – a long exposure to the asset- Long put – a short exposure to the asset

• Income (yield) enhancement - Selling a call option on a portfolio to gain extra income- This is known as a ‘covered call’

• Protecting a portfolio (hedging)- Buying a put option on a portfolio to give protection in a falling market

3. Securities and Derivatives Markets

Answer to the question on the previous slide = CA put is a right to sell. It starts to make money when the asset price falls below the exercise price. The payoff is calculated as follows:

Now: Put is OTM (out-the-money), therefore return from option = £0.Net payoff = £0 - £1.50 premium = -£1.50.

Share price = £10: Put is ATM (at-the-money), therefore return from option = £0. Net payoff = £0 - £1.50 premium = -£1.50.

Share price = £7: Put is ITM (in-the-money), therefore return from option = £10 - £7 = £3.00. Net payoff = £3.00 - £1.50 premium = +£1.50.

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Knowledge | Skills | Conduct

OTC Traded on exchange

Contract terms Bespoke: Tailored to meet the needs of the investor

Contract specificationsstandardised by the exchange

Liquidity Limited, giving slower execution Excellent on major contracts

Margin Normally no margin Margin normally required

Regulation

Less stringent regulation ofproductsMore stringent restrictions on whomay invest in them

Exchanges subject to significant regulation

Counterparty risk Exposed to default risk No member default risk due to clearing house

Reporting Confidentiality Market transparency

Price Negotiated or ‘request for quote’ Best execution

HedgingSpecific hedging requirements canbe met

Hedges based on standardisedcontracts need to be activelymanaged

(7.3.3) Forwards

3. Securities and Derivatives Markets

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Further InformationCDS typesThere are three basic types of credit default swap:Basic: Where protection is bought on a specific reference asset, such as a particular bond.Index: Where the reference asset is a bond, equity or market index. Generally the protection is bought against a price fall below a pre-specified level. This type of CDS is closely linked to a total return swap.Basket: Where a collection of specific bonds can be pooled into a portfolio and protection is bought against that portfolio. Payments could be triggered by the first to default, or a pre-specified number to default.The recovery rate could be market price of the bond following default or the amount recovered by creditors on liquidation of a company’s assets.

HintsAlthough, strictly speaking, a credit downgrade is not classified as a credit event, it could be an indication of a potential default situation, leading to a significant fall in the bond price and thus making the credit default swap attractive.

Knowledge | Skills | Conduct

(7.3.5) Credit default swaps (CDSs)

• Credit event- Failure to pay (default)- Bankruptcy- Restructuring

• Payout- Physically delivered: Bond exchanged for bond value- Cash-settled: Investor receives bond value less recovery rate

3. Securities and Derivatives Markets

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Further Information Systemic riskSystemic risk – associated with the interdependencies within a system or market, where the failure of a single participant or number of participants can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. The systemic risk of a financial institution is the likelihood and the degree that the institution's activities will negatively affect the larger economy so much so that governmental intervention would be required to correct the effects.

HintsCorrelation coefficients are useful to portfolio managers in two ways.Assets with a low correlation coefficient allow the manager to reduce the portfolio’s risk.When a manager identifies an attractive investment asset that may be too expensive or restricted or illiquid, she can try to find an attractive alternative by using an asset with a high correlation coefficient.

Knowledge | Skills | Conduct

(7.4.1) An overview of portfolio risk• Systemic risk

- Affects the financial system as a whole

• Systematic (market) risk (cannot be diversified away)- Equity risk- Interest rate risk- Currency risk- Commodity risk

• Specific risk (can be diversified away)- Issuer risk (credit risk)- Liquidity

• Diversification- Combining securities whose returns are not perfectly positively correlated

• Increase the number of holdings• Invest in different asset classes, different industry sectors, different countries etc.

4. Portfolio Risk

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Knowledge | Skills | Conduct

(7.5.3) Active and passive management strategies

• The efficient markets hypothesis (EMH)- Assumes that because information about firms/shares is freely available that shares

will be correctly priced on stock markets

5. Mitigating Portfolio Risk

The Weak Form

The Semi-strong Form

The Strong Form

The market price of shares reflects all relevant information implied in:• Historic share prices

The market price of shares reflects all relevant information implied in:• Historic share prices • All publicly available information

The market price of shares reflects all relevant information implied in:• Historic share prices• All publicly available information• All private information

The Three Forms of the Efficient Market Hypothesis

HintsThe weak form of efficient markets hypothesis eliminates the need for technical analysis.The semi-strong form of efficient markets hypothesis eliminates the need for fundamental analysis.

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Further InformationTracker fund replication methodsConstructing a tracker fund is commonly achieved via one of the four following methods:Replication: Buy all of the shares in the benchmark, in the same weighting as the index. Although this is very accurate, it involves regular and significant rebalancing – the transaction costs for which can eat into investment returns.Sampling: This involves buying the most influential shares in the index. This involves having to rebalance fewer stocks, therefore cutting transaction costs, but is less accurate than replication.Synthetic: Here, the portfolio manager uses futures representing the index to track index returns. This is very cheap, but introduces basis risk. Optimisation: This involves using complex mathematical modelling to construct a portfolio of assets whose returns are most strongly positively correlated with those of the index.

Knowledge | Skills | Conduct

(7.5.3) Active and passive management strategies

Passive fund management

• A belief that markets are efficient and that share prices reflect their true worth

• Semi-active- Enhanced indexing or tilting

5. Mitigating Portfolio Risk

Advantages Disadvantages• Aims for long-term appreciation and

limited maintenance

• Low fund management fees

• Portfolios are easier to construct and monitor

• Less capital gains tax due to less trading

• No prospect of outperformance (‘alpha’)

• Passive portfolios can still have tracking error as it can be difficult to fully replicate the returns of the index

• Miss out on short-term tactical investment opportunities

• At the mercy of the markets

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Further InformationActive equity portfolio management strategiesValue funds: screening the market for shares that are outstandingly cheap, compared with their benchmarkGrowth funds: buying growth shares early, particularly of companies in fast growing markets with barriers to entryGrowth-at-reasonable-price (GARP) funds: reconciling value and growth approaches, whereby growth investors use a ‘filter’ to reject those stocks whose P/E ratio is unrealistically high. The filter is to check the P/E is equal to, or lower than, the company’s annual rate of earnings growth.Quantitative funds: the use of statistical and mathematical models to identify under- or over-valued sharesBuy-and-hold funds: buying and holding a portfolio of securities with only minor and infrequent adjustments over time

Keeping on TargetWhich of the following would form part of a passive rather than active portfolio management style?A. Buying index based equity derivatives which emulates the FTSE 100B. Selling short securities that are overvaluedC. Selecting securities based on quantitative research and P/E ratios of

similar sector companiesD. Hedging existing securities using over-the-counter derivatives to take

advantage of out of hours trading opportunities

Knowledge | Skills | Conduct

(7.6.1) Active and passive management strategies

Active fund management

• Believes in market failure and attempts to outperform a benchmark

• Top-down- Asset allocation

• Proportion in cash, equity and bonds

- Sector selection• For instance, looking at proportion in sensitive sectors, such as financials, and those in less

sensitive sectors, such as utilities

- Stock selection• Seeking out mispriced stocks

• Bottom-up- Focuses on stock first

6. Key Approaches to Investment Allocation

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Answer to the question on the previous slide = APassive management is constructing a portfolio to track or mimic the performance of an index. Using equity index-based derivatives can emulate the total returns without requiring an outright purchase of the shares of the companies within the FTSE 100.

Keeping on TargetA company wishes to fund the repayment of the principal of a £2,000,000 mortgage in five years. Which of the following gilt strategies would be the most appropriate?A. Buy £2,000,000 nominal of a five-year gilt stripB. Buy less than £2,000,000 nominal of a five-year coupon paying gilt,

reinvesting the coupons over the periodC. Buy £2,000,000 nominal of a five-year coupon paying gilt, reinvesting

the coupons over the periodD. Buy more than £2,000,000 nominal of a five-year coupon paying gilt,

reinvesting the coupons over the periodKnowledge | Skills | Conduct

(7.7.6) Active bond portfolio management• Anomaly switching

- Pure yield pick up• Switching between two similar bonds with differing prices

- Substitution switching• As above, but reverses the switch once the correction occurs

• Policy switching- Switching between two dissimilar bonds to take advantage of changes

• Riding the yield curve- Buys a longer-term bond than needed and sell before maturity

(7.7.7) Passive bond portfolio management• Cash matched/dedicated portfolios

- Matching cash flow of bonds to the liabilities• Duration matching/Immunisation

- Matching the duration of bonds to the liabilities• Combined matching (horizon matching)

- Cash match the near-dated liabilities and duration match the longer-dated liabilities

7. Bond Portfolio ManagementHintsRiding the yield curve – allows the bondholder to profit from the declining yield that occurs over the life of the bond. The investor is exposed to movements in the yield curve; this risk is taken to enhance returns.

169

Further InformationHolding Period ReturnHolding period return is a form of total or absolute return. It can be adapted to include cash flows to and from the fund.

val Startreceived Income val) Start - val (End return Total

Answer to the question on the previous slide = AThe £2,000,000 strip is certain to raise the needed capital. Strips can precisely meet the liabilities of the investor, removing any ‘reinvestment risk’ that is normally faced when covering liabilities with coupon paying bonds.Buying less than £2,000,000 and reinvesting the coupons is a possibility, but there is no guarantee that the reinvested coupons will meet the liability. The other two strategies would involve the commitment of too much capital, and would ultimately generate more than the needed amount.

Knowledge | Skills | Conduct

Please note: The topics in the rest of this chapter are not examinable via calculations.

(7.8.1) Holding period return and total return

• Risk and potential reward- Positively correlated

• Low risk investments provide lower expected returns and a lower possibility of loss• Higher risk investments have the potential for higher returns, and a greater possibility of loss

• Holding period return calculations

• Example: The value of a portfolio at the start of year one is $97.5m. At the end of the annual period it has grown to $104.5m. Calculate the holding period return.

8. Evaluation of Portfolio Risk and Return

START

STARTEND

ValValValHPR

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Knowledge | Skills | Conduct

(7.8.6) Time-weighted and money-weighted returnsThe time-weighted return (TWR)• Period of investment is broken into sub-periods based on cash flows

- ‘Unitised approach’

• The compound rate of return over these time periods• Unaffected by timings and size of cash flows in and out of the portfolio• Preferred industry standard

The money-weighted return (MWR)• Considers inflows and outflows of cash to the portfolio• A single rate of return is attributed to the whole period of investment• The return is given relative to the length of the period of investment• Also known as the internal rate of return of cash flows

8. Evaluation of Portfolio Risk and Return

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Further InformationProblems with using standard deviation• It is based on past patterns of returns, which may not be

representative of future patterns in returns• It assumes that upside is equally as likely as downside – the

standard deviation, by definition, is the average upside or downside movement

• Volatility generally is not a complete measure of risk Value at Risk (VAR)To measure the degree of financial or market risk being endured within a firm or an investment, we can use value at risk (VAR). It is a widely used risk measure of the risk of loss on a particular portfolio of financial instruments.For the given portfolio, time horizon, and probability, the VAR is defined as a threshold loss value. This assumes mark-to-market pricing, normal markets and no trading within the portfolio. VAR is measured in three components:1. The amount of potential loss.2. The time frame.3. The probability that amount of loss will happen.

Knowledge | Skills | Conduct

(7.8.3) Volatility

Stock J is clearly more volatile than Stock K.

The standard deviation around the mean ( ) will be larger for stock J.

Standard deviation ( ) is used to measure the comparative risk of stocks.

8. Evaluation of Portfolio Risk and Return

time time

Ret

urns

Ret

urns

R-K0

σ

R-J

R-J0

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Further InformationDrawdown measure of riskArguably, standard deviation is a difficult measure of risk for some clients to interpret or understand. Drawdown is an alternative measure of risk, and calculates the ‘peak to trough’ differences in prices over a set time period. Showing the worst case variability of price is easier for some clients to readily interpret.

Knowledge | Skills | Conduct

(8.4.5) Drawdown measure of risk

• A worst-case variability in price

8. Evaluation of Portfolio Risk and Return

Price

Time (months)

50

100

150

200

250Max 1215

Min 1110

Min 2165

Max 2280

1 2 3 4 5 6 7 8 9 10

300

Values in FinanceRespect and tolerance – inclusionThe drawdown measure of risk is intended to create a measure that is understandable to investors of all levels of experience.

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Keeping on TargetAn analyst is presenting his findings in relation to the capital asset pricing model. He stresses the importance of identifying non-zero Alpha stock relative to the securities market line when stock-picking. Why might this be? I. Non-zero Alpha stock may show an overvalued stock and give you a

signal to sellII. Non-zero Alpha stock may show a correctly valued stock and give you a

signal to holdIII. Non-zero Alpha stock may show an undervalued stock and give you a

signal to buyIV. Non-zero Alpha stock shows the stock that incurs extra service costs

when buying and sellingA. I onlyB. II onlyC. I and IIID. IV only

Knowledge | Skills | Conduct

(7.7.1) Active equity selection strategies

• The capital asset pricing model (CAPM)- CAPM calculates the expected return from a security given its systematic risk (Beta)- Assets are referenced to the securities market line- A security is said to be mispriced if it has a non-zero Alpha value

• Alpha (Jensen)

8. Evaluation of Portfolio Risk and Return

CAPMby predicted return the is

portfolio the to return the is Where

measure Jensen

CAPM

p

CAPMp

R

R

RR

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Keeping on TargetConsider the following information about four diversified funds.Fund A: Return = 7.68%, Volatility = 2.65%, Treynor measure = 6.45Fund B: Return = 6.58%, Volatility = 1.55%, Treynor measure = 4.33Fund C: Return = 4.81%, Volatility = 2.10%, Treynor measure = 5.9Fund D: Return = 7.15%, Volatility = 2.77%, Treynor measure = 6.75Which fund has the highest risk adjusted return? A. Fund AB. Fund BC. Fund CD. Fund D

Keeping on TargetWhich of the following statements about the Sharpe ratio is true?A. It considers systematic risks of a portfolio onlyB. It is calculated as the excess return of the portfolio above the risk-free rate

divided by the portfolio’s betaC. It can be used to make comparisons between undiversified portfoliosD. It is based on the Capital Asset Pricing Model

Answer to the question on the previous slide = CThe Alpha is referring performance relative to the securities markets line (SML) or the Jensen Measure.With all this on board, a non-zero Alpha would show:• A security that performs above (+A) or below (-A) the SML• A security that performs above (+A) or below (-A) expectation; and• A security is undervalued (+A) or overvalued (-A) by the market

Knowledge | Skills | Conduct

(7.8.5) Risk-adjusted returns

Sharpe

• Useful for undiversified portfolios

Treynor

• Useful for diversified portfolios

8. Evaluation of Portfolio Risk and Return

portfolio. the of deviation standard the Is

return. free risk the is

portfolio. the to return the is :Where

Sharpe

p

f

p

p

fp

σ

R

R

σRR

portfolio. the of beta the Is

return. free risk the is

portfolio. the to return the is :Where

Treynor

p

f

p

p

fp

β

R

R

βRR

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Knowledge | Skills | Conduct

Market Information and Research

• Use of official communications

• Types of research and reports

• Key influences on markets and sectors

Use of Derivatives

• Relationship between securities and derivatives

• Relationship between different forms of fixed income security

Portfolio Risk and Management Strategies

• Portfolio risk

• Mitigating portfolio risk

• Investment allocation

• Management strategies and styles

Evaluation of Portfolio Risk and Return

• Performance measure

Chapter Review

176