Portfolio Management in Practice, Volume 2

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 xiiiAcknowledgments xvAbout the CFA Institute Investment Series xviiChapter 1 Basics of Portfolio Planning and Construction 11. Introduction 12. Portfolio Planning 22.1. The Investment Policy Statement 22.2. Major Components of an IPS 32.3. Gathering Client Information 173. Portfolio Construction 193.1. Capital Market Expectations 203.2. The Strategic Asset Allocation 203.3. Steps Toward an Actual Portfolio 283.4. ESG Considerations in Portfolio Planning and Construction 323.5. Alternative Portfolio Organizing Principles 334. Conclusion and Summary 34References 35Practice Problems 36Chapter 2 Security Market Indexes 411. Introduction 412. Index Definition and Calculations of Value and Returns 422.1. Calculation of Single-Period Returns 432.2. Calculation of Index Values over Multiple Time Periods 453. Index Construction and Management 463.1. Target Market and Security Selection 463.2. Index Weighting 473.3. Index Management: Rebalancing and Reconstitution 564. Uses of Market Indexes 584.1. Gauges of Market Sentiment 584.2. Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk-Adjusted Performance 584.3. Proxies for Asset Classes in Asset Allocation Models 584.4. Benchmarks for Actively Managed Portfolios 594.5. Model Portfolios for Investment Products 595. Equity Indexes 595.1. Broad Market Indexes 595.2. Multi-Market Indexes 605.3. Sector Indexes 615.4. Style Indexes 626. Fixed-Income Indexes 636.1. Construction 636.2. Types of Fixed-Income Indexes 637. Indexes for Alternative Investments 667.1. Commodity Indexes 667.2. Real Estate Investment Trust Indexes 667.3. Hedge Fund Indexes 678. Summary 70Practice Problems 71Chapter 3 Capital Market Expectations, Part 1: Framework and Macro Considerations 771. Introduction 782. Framework and Challenges 782.1. A Framework for Developing Capital Market Expectations 792.2. Challenges in Forecasting 823. Economic and Market Analysis 903.1. The Role of Economic Analysis 903.2. Analysis of Economic Growth 913.3. Approaches to Economic Forecasting 963.4. Business Cycle Analysis 1003.5. Analysis of Monetary and Fiscal Policy 1083.6. International Interactions 1174. Summary 121References 124Practice Problems 125Chapter 4 Capital Market Expectations, Part 2: Forecasting Asset Class Returns 1311. Introduction 1322. Overview of Tools and Approaches 1322.1. The Nature of the Problem 1322.2. Approaches to Forecasting 1333. Forecasting Fixed-Income Returns 1343.1. Applying DCF to Fixed Income 1343.2. The Building Block Approach to Fixed-Income Returns 1363.3. Risks in Emerging Market Bonds 1424. Forecasting Equity Returns 1454.1. Historical Statistics Approach to Equity Returns 1454.2. DCF Approach to Equity Returns 1464.3. Risk Premium Approaches to Equity Returns 1484.4. Risks in Emerging Market Equities 1535. Forecasting Real Estate Returns 1545.1. Historical Real Estate Returns 1545.2. Real Estate Cycles 1555.3. Capitalization Rates 1565.4. The Risk Premium Perspective on Real Estate Expected Return 1575.5. Real Estate in Equilibrium 1585.6. Public vs. Private Real Estate 1585.7. Long-Term Housing Returns 1606. Forecasting Exchange Rates 1616.1. Focus on Goods and Services, Trade, and the Current Account 1626.2. Focus on Capital Flows 1647. Forecasting Volatility 1707.1. Estimating a Constant VCV Matrix with Sample Statistics 1707.2. VCV Matrices from Multi-Factor Models 1707.3. Shrinkage Estimation of VCV Matrices 1727.4. Estimating Volatility from Smoothed Returns 1737.5. Time-Varying Volatility: ARCH Models 1748. Adjusting a Global Portfolio 1758.1. Macro-Based Recommendations 1758.2. Quantifying the Views 1789. Summary 179References 181Practice Problems 183Chapter 5 Overview of Asset Allocation 1911. Introduction 1912. Asset Allocation: Importance in Investment Management 1933. The Investment Governance Background to Asset Allocation 1943.1. Governance Structures 1953.2. Articulating Investment Objectives 1953.3. Allocation of Rights and Responsibilities 1973.4. Investment Policy Statement 1983.5. Asset Allocation and Rebalancing Policy 1993.6. Reporting Framework 1993.7. The Governance Audit 1994. The Economic Balance Sheet and Asset Allocation 2015. Approaches to Asset Allocation 2055.1. Relevant Objectives 2075.2. Relevant Risk Concepts 2085.3. Modeling Asset Class Risk 2096. Strategic Asset Allocation 2156.1. Asset Only 2176.2. Liability Relative 2226.3. Goals Based 2257. Implementation Choices 2307.1. Passive/Active Management of Asset Class Weights 2307.2. Passive/Active Management of Allocations to Asset Classes 2317.3. Risk Budgeting Perspectives in Asset Allocation and Implementation 2358. Rebalancing: Strategic Considerations 2368.1. A Framework for Rebalancing 2388.2. Strategic Considerations in Rebalancing 2399. Summary 241References 242Practice Problems 244Chapter 6 Principles of Asset Allocation 2471. Introduction 2482. Developing Asset-Only Asset Allocations 2492.1. Mean–Variance Optimization: Overview 2492.2. Monte Carlo Simulation 2622.3. Criticisms of Mean–Variance Optimization 2652.4. Addressing the Criticisms of Mean–Variance Optimization 2672.5. Allocating to Less Liquid Asset Classes 2792.6. Risk Budgeting 2802.7. Factor-Based Asset Allocation 2833. Developing Liability-Relative Asset Allocations 2873.1. Characterizing the Liabilities 2873.2. Approaches to Liability-Relative Asset Allocation 2903.3. Examining the Robustness of Asset Allocation Alternatives 3023.4. Factor Modeling in Liability-Relative Approaches 3044. Developing Goals-Based Asset Allocations 3044.1. The Goals-Based Asset Allocation Process 3064.2. Describing Client Goals 3084.3. Constructing Sub-Portfolios 3104.4. The Overall Portfolio 3144.5. Revisiting the Module Process in Detail 3154.6. Periodically Revisiting the Overall Asset Allocation 3194.7. Issues Related to Goals-Based Asset Allocation 3205. Heuristics and Other Approaches to Asset Allocation 3215.1. The “120 minus your age” rule 3215.2. The 60/40 stock/bond heuristic 3235.3. The endowment model 3235.4. Risk parity 3245.5. The 1/N rule 3266. Portfolio Rebalancing in Practice 3267. Conclusions 331References 332Practice Problems 335Chapter 7 Asset Allocation with Real-World Constraints 3451. Introduction 3452. Constraints in Asset Allocation 3462.1. Asset Size 3462.2. Liquidity 3522.3. Time Horizon 3552.4. Regulatory and Other External Constraints 3593. Asset Allocation for the Taxable Investor 3643.1. After-Tax Portfolio Optimization 3653.2. Taxes and Portfolio Rebalancing 3693.3. Strategies to Reduce Tax Impact 3704. Revising the Strategic Asset Allocation 3745. Short-Term Shifts in Asset Allocation 3815.1. Discretionary TAA 3825.2. Systematic TAA 3836. Dealing with Behavioral Biases in Asset Allocation 3866.1. Loss Aversion 3876.2. Illusion of Control 3876.3. Mental Accounting 3886.4. Representativeness Bias 3896.5. Framing Bias 3906.6. Availability Bias 3917. Summary 394References 396Practice Problems 397Chapter 8 Asset Allocation to Alternative Investments 4071. Introduction 4072. The Role of Alternative Investments in a Multi-Asset Portfolio 4082.1. The Role of Private Equity in a Multi-Asset Portfolio 4112.2. The Role of Hedge Funds in a Multi-Asset Portfolio 4122.3. The Role of Real Assets in a Multi-Asset Portfolio 4122.4. The Role of Commercial Real Estate in a Multi-Asset Portfolio 4132.5. The Role of Private Credit in a Multi-Asset Portfolio 4143. Diversifying Equity Risk 4143.1. Volatility Reduction over the Short Time Horizon 4143.2. Risk of Not Meeting the Investment Goals over the Long Time Horizon 4184. Perspectives on the Investment Opportunity Set 4204.1. Traditional Approaches to Asset Classification 4214.2. Risk-Based Approaches to Asset Classification 4244.3. Comparing Risk-Based and Traditional Approaches 4295. Investment Considerations Relevant to the Decision to Invest in Alternatives 4315.1. Risk Considerations 4315.2. Return Expectations 4325.3. Investment Vehicle 4325.4. Liquidity 4345.5. Fees and Expenses 4385.6. Tax Considerations 4385.7. Other Considerations 4396. Suitability Considerations 4426.1. Investment Horizon 4426.2. Expertise 4426.3. Governance 4426.4. Transparency 4437. Asset Allocation Approaches 4457.1. Statistical Properties and Challenges of Asset Returns 4467.2. Monte Carlo Simulation 4517.3. Portfolio Optimization 4587.4. Risk Factor-Based Optimization 4658. Liquidity Planning 4698.1. Achieving and Maintaining the Strategic Asset Allocation 4708.2. Managing the Capital Calls 4768.3. Preparing for the Unexpected 4769. Monitoring the Investment Program 4809.1. Overall Investment Program Monitoring 4809.2. Performance Evaluation 4819.3. Monitoring the Firm and the Investment Process 48310. Summary 485References 487Practice Problems 488Chapter 9 Exchange-Traded Funds: Mechanics and Applications 4971. Introduction 4972. ETF Mechanics 4982.1. The Creation/Redemption Process 4992.2. Trading and Settlement 5033. Understanding ETFs 5043.1. Expense Ratios 5043.2. Index Tracking/Tracking Error 5053.3. Tax Issues 5113.4. ETF Trading Costs 5123.5. Total Costs of ETF Ownership 5183.6. Risks 5214. ETFs IN PORTFOLIO MANAGEMENT 5264.1. ETF Strategies 5264.2. Efficient Portfolio Management 5264.3. Asset Class Exposure Management 5284.4. Active and Factor Investing 5305. Summary 533Practice Problems 536Chapter 10 Case Study in Portfolio Management: Institutional 5411. Introduction 5412. Background: Liquidity Management 5422.1. Liquidity Profiling and Time-to-Cash 5432.2. Rebalancing, Commitments 5452.3. Stress Testing 5462.4. Derivatives 5472.5. Earning an Illiquidity Premium 5473. QUINCO Case 5483.1. Quadrivium University Investment Company (QUINCO) 5503.2. Investment Strategy: Background and Evolution 5513.3. Strategic Asset Allocation 5533.4. Liquidity Management 5583.5. Asset Manager Selection 5633.6. Tactical Asset Allocation 5653.7. Asset Allocation Rebalancing 5704. Summary 574References 575Practice Problems 576Glossary 581About the Authors 587About the CFA Program 589Index 591