High risk, high return

negatively skewed
Return distribution
Historical greater kurtosis
risk & return
major concern in emerging markets
Liquidity
infrequently traded securities

financial model
risk-averse investor assumption

Risk aversion risk-seeking (risk-loving) investor

investor types risk-neutral investor

utility functions

indifference curve slope for investor types

--> risk aversion coefficient.

Optimal two-fund separation theorem

capital allocation line
portfolio function

finding optimal portfolio

population

Variance

sample

Covariance
Portfolio
standardized measure
standard
Correlation
deviation

Portfolio
standard
deviation

ρ12 = +1

ρ12 = 0
Effect of
correlation ρ12 = -1

--> The lower the correlation of asset returns,

the greater the risk reduction (diversification)
benefit of combining assets in a portfolio

market portfolio
minimum-variance portfolios that has the least risk
Efficient
frontier lowest standard deviation of all portfolios
minimum-variance frontier with a given expected return are known

greatest expected return

efficient frontier for each level of risk

global minimum-variance portfolio

Portfolio combination of risk-free
metrics and risky assets

The line of possible port. risk & return combinations

given risk-free rate & risk-return of a port. of risky assets
CAL
The optimal risky portfolio for investor

assumes investors have homogeneous expectations

--> all investors efficient frontier of risky port.

face the same
same optimal risky port. and CAL

CML --> market port. --> CML

Allocation line
function

market risk
premium

Borrowing and Lending Portfolios

Applications
passive and active investment strategy

also called unique, diversifiable, or firm-specific risk

unsystematic risk
risk that is eliminated by diversification

also called nondiversifiable risk or market risk

systematic risk
risk that remains cannot be diversified away

measured by standard deviation

total risk
= systematic risk + unsystematic risk
Types of risk
Academic studies have shown that as you increase the number of stocks
in a port., the port.'s risk falls toward the level of market risk

unsystematic risk is not compensated in equilibrium

Systematic risk is measured by the contribution

Applications of a security to the risk of a well-diversified port.

expected equilibrium return (required return) on an

individual security will depend only on its systematic risk
 used to estimate the expected returns on risky
securities based on specific factors

Multifactor models

macroeconomic

Factor types fundamental

statistical
Return
generating risk-free rate
models factor sensitivity
general form
(or factor loading)

expected value of factor

Fama French model

Applications
Carhart model

A simplified form of a single-index model

Function

The sensitivity of an asset's return to

the return on the market index

Beta
Market
model

In practice, we estimate asset betas by regressing

returns on the asset on those of the market index

regression line is referred to as the

asset's security characteristic line

security market
line (SML)

CAPM function

Risk aversion

Utility maximizing investors

Frictionless markets

CAPM Assumptions One-period horizon

Homogeneous expectations

Divisible assets

Competitive markets

CML only applies to efficient port.

CML vs SML
SML applies to all assets and port.
 Estimate a security's required return
--> making capital budgeting decisions

Identifying mispriced securities

CAPM applications Portfolio
construction maximize risk-adjusted return

Performance evaluation

Attribution analysis

Sharpe ratio total risk

slope

Performance
Appraisal
Measures
M-squared total risk

percentage

systematic risk
Treynor
slope

Jensen's alpha systematic risk

percentage
Prepared by Trustville

evaluating individual investments by

their contribution to the risk and
return of an investor’s portfolio
Portfolio
perspective diversification allows an investor to reduce
portfolio risk without necessarily reducing
the portfolio’s expected return

framework for measuring

the risk-reduction benefits
Harry Markowitz of diversification

Treynor, Sharpe, modern port. theory (MPT)

Mossin, and Lintner
Portfolio market risk
Approach History
ratio of the risk of an equally weighted
to Investing portfolio of n securities

divided to the risk of a single security

Diversification ratio selected at random from the n securities

A lower diversification ratio

--> greater risk-reduction benefit

Portfolio diversification works best when financial markets are operating normally

Risk tolerance

Return objectives

Time horizon

Inputs Tax exposure

Liquidity needs

Planning Income needs

Unique circumstances

Outputs IPS

analysis of the risk and return

Asset characteristics of asset classes
allocation
top-down analysis

Portfolio Execution
identify the most attractive
Management Security securities within the asset class
selection
Process bottom-up security analysis

investor circumstances
Monitor
risk and return characteristics
changes
of asset classes

actual weights of the assets in the port.

Feedback rebalance the port. periodically in response

measure portfolio performance

evaluate performance relative to benchmark

Prepared by Trustville

Types of
investors

Defined benefit Investment risk: employers

Pension plan Defined contribution Investment risk: employees

firms that manage investments for clients

independent managers
Legal entity
divisions of larger financial services companies

buy-side firms
Function
sell-side firms

Full-service asset managers

Assets
Investment styles Specialist asset managers
management
multi-boutique firm
industry
Passive vs active management smart beta

traditional
Asset classes
alternative

The market share for passive management

Trends The amount of data available to asset managers

Robo-advisors

Mechanic Net asset value (NAV)

Open-end no-load vs. load fund

Mutual
fund Closed-end

Money market

Bond
Types
Passively managed Index fund
Stock
Actively managed
Pooled
investment ETF Mechanic
funds Separately manage account

Hedged fund

Private equity

Venture capital
Prepared by Trustville

Description of Client

Statement of the Purpose

investment manager

Statement of Duties & Responsibilities custodian of assets

client

Procedures to update IPS

IPS Investment Objectives

Investment Constraints

Investment Guidelines

Evaluation of Performance

Strategic asset allocation

Appendices Tactical asset allocation

Rebalance

Absolute
Risk
Relative

Return
Objectives
Ability objective
Risk tolerance
willingness subjective

Time horizon

Tax situations

Liquidity needs
Constraints
Legal and regulatory

Unique circumstances responsible investing

domestic or foreign

Equity large or small cap

emerging or developed

maturities

domestic or foreign
Asset class Bond
definition government or corporate

investment grade or speculative

Cash

real estate
SAA
Alternative hedge fund, PE, venture

commodity

Capital market expectation

Allocation mean-variance optimization

Portfolio TAA
construction
Security selection

Risk budgeting

1. Benchmark overlap

Active PM issues 2. Excessive trading

--> core-satellite approach

environmental, social, and governance (ESG)

negative, positive screening

ESG investing
thematic, impact investing
approaches
engagement/active ownership

ESG integration
Prepared by Trustville

faulty reasoning
due primarily to
irrationality

not understanding statistical analysis

arise from information processing errors

illogical reasoning, or memory errors

Cognitive
errors increased awareness

errors can possibly be reduced by better training

more information

Belief
perseverance an irrational reluctance to change
biases prior conclusions and decisions
Category
types
Processing
errors information analysis is flawed

not related to conscious thought

Emotional
biases stem from feelings, impulses, or intuition

difficult to overcome and may have to be accommodated

rationally form an initial view but then

Conservatism
fail to change that view as new info becomes available

focus on or seek info that supports prior beliefs,

Confirmation
while avoiding or diminishing the importance of
conflicting info or viewpoints

certain characteristics are used to

put an investment in a category and

the individual concludes that it will have the

Representativeness characteristics of investments in that category

Belief Base-rate neglect

Forms
perseverance Sample-size neglect
biases
market participants believe they can control
or affect outcomes when they cannot

Illusion of control illusion of knowledge

often associated with
emotional biases self-attribution

overconfidence

selective memory of past events, actions,

or what was knowable in the past
Hindsight
resulting in an individual’s tendency to see things as
more predictable than they really are
Prepared by Trustville

decisions are affected by the way in which

Framing the question or data is “framed.”

basing expectations on a prior number

and overweighting its importance
Anchoring &
adjustment
making adjustments in relation to
that number as new info arrives
Processing
Mental viewing money in different accounts or from different
errors accounting sources differently when making investment decisions

readily available

putting undue emphasis easy to recall

Availability on info that is
based narrowly on
personal experience
or knowledge

feeling more pain from a loss

Loss-aversion than pleasure from an equal gain

market participants overestimate their own

Overconfidence intuitive ability or reasoning

individuals lack self-discipline and

Self-control
favor short-term satisfaction over long-term goals

Emotional comfort with an existing situation causes

biases Status quo an individual to be resistant to change

an asset is felt to be special and more valuable

Endowment simply because it is already owned

market participants do nothing out of excessive

fear that actions could be wrong
Regret-aversion
Herding behavior

Market anomalies

availability

Momentum partly explained by hindsight

loss aversion

Overconfidence

How BF influences self-attribution

market behavior Bubbles &
crashes Confirmation bias

Anchoring

Fear of regret

Halo effect
Value
Home bias
Prepared by Trustville

identify risk tolerance

identify and measure risk

Objective
modify and monitor risk

processes and policies for risk governance

determine risk tolerance

identify and measure risk

manage and mitigate risk

Framework
monitor risk exposure

communication

risk analysis

determine risk tolerance

Risk governance framework for oversight

allocate firm resources to assets

Risk budgeting

credit

financial liquidity

market
Types of risks
non-financial

Equity std, beta

Fixed Income Duration, Convexity

Measures of risk Derivatives Delta, Gamma, Vega, Rho

Value-at-Risk (VaR) downside risk

self-insure

transfer
Modify risk
shifting