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Table of Contents
Reading 51: Portfolio Management: An Overview ................................................................................. 2
Reading 52: Portfolio Risk and Return: I ................................................................................................. 3
Reading 53: Portfolio Risk and Return: Part II ........................................................................................ 4
Reading 54: Basics of Portfolio Planning and Construction .................................................................... 6
Reading 55: Introduction to Risk Management ...................................................................................... 7
Reading 56: Technical Analysis ............................................................................................................... 8
Reading 57: Fintech in Investment Management ................................................................................. 12
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Reading 51: Portfolio Management: An Overview
Steps in portfolio management process
● Planning: List client’s objectives and constraints in IPS
● Execution: This includes asset allocation, security analysis and portfolio construction.
● Feedback: This includes monitoring/rebalancing and performance measurement and
reporting.
Types of investors
Client Investment Risk tolerance Income needs Liquidity needs
horizon
Individual investor Varies by Depends on the Depends on Varies by
individual ability and investment individual.
willingness to rationale
take risk
Defined benefit Usually long High for longer High for mature Varies by plan
(DB) pension plans term investment funds (payouts maturity
horizon soon), low for
growing funds.
Endowments & Very long term Typically high To meet spending Quite low
foundations commitments
Banks Short term Low Pay interest on High, to meet
deposits and daily
operational withdrawals
expenses
Insurance Short term for Low Low High to meet
companies property & claims
casualty (P&C),
long term for
life insurance
Investment Varies by fund Varies by fund Varies by fund High to meet
companies redemptions
Sovereign wealth Varies by fund Varies by fund Varies by fund Varies by fund
funds
Defined benefit AND defined contribution pension plans
• Defined benefit plan is where a company promises to makes a pre-defined future benefit
payments to the employees. The company bears the investment risk.
• Defined contribution plan is where a company contributes an agreed amount to the plan
and employees invest part of their wages to the plan. In a plan, investment and inflation risk
is borne by the employee.
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Reading 52: Portfolio Risk and Return: I
Risk aversion
● Risk aversion is the degree of an investor’s inability and unwillingness to take risk.
● Risk neutral: an investor who is indifferent about the gamble or a guaranteed outcome, as
the investor is only concerned about returns.
● Risk-seeking: an investor who prefers a gamble, where the indifference curve is downward
sloping as the expected return decreases for higher levels of risk. This is uncommon.
● Risk averse: an investor who expects additional return for taking additional risks, i.e. the
indifference curve is upward sloping. Most investors are risk averse, the degree of risk
aversion varies. The steeper the indifference curve, the more risk averse they are.
Minimum variance portfolio
● Minimum variance frontier is a line combining all portfolios with a minimum level of risk
given a rate of return.
● Global minimum variance portfolio is the portfolio with the lowest variance amongst the
portfolio of all risky assets.
● The efficient frontier is the part of the minimum variance frontier that is above the global
minimum variance portfolio, since it gives the highest return for a given level of risk. Note
that efficient frontier only consists of risky assets, there are no risk-free assets here.
Capital allocation line (CAL)
CAL overcomes the shortfall of efficient frontier by showing a line representing possible
combinations of risk-free assets and optimal risky asset portfolio.
E[RP] = RF+ (E[RI] – RF/ std. deviation of I ) Std. deviation of p
Optimal investor portfolio is the point where an investor’s indifference curve is tangential to the
optimal CAL.
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Reading 53: Portfolio Risk and Return: Part II
Capital market line (CML)
If all investors have the same expectations, the capital market line (CML) becomes a special case of
optimal CAL, where the tangent portfolio is the market portfolio.
CML is a special case of CAL whereby
E(RP) = Rf + (E(RM)-RF/σ M ) σ P
Slope of CML line is the market price of risk, i.e. Sharpe ratio.
Systematic vs non-systematic risk
● Systematic risk is a non-diversifiable, market risk. Investors should get compensated for
taking on systematic risk.
● Non-systematic risk is a local risk that can be diversified away, investors are not
compensated for taking on this risk.
● A risk-free asset has zero systematic and non-systematic risk.
Beta
Beta is a measure of an asset’s systematic (market) risk, relative to the risk of the overall market.
Bi =Co vim/σm2
We can also put in in the context of correlation
P I m= Co vim/σ i σ m
To get
Co vim = Pim σi σm
We can also tweak the equation for BETA
Βi= Pimσiσm / σ2m = Pim(σi/σm)
Capital asset pricing model (CAPM)
CAPM is used to calculate an asset’s required return given its beta.
E(Ri) = Rf + βi [E(Rmkt ) – Rf ]
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CAPM assumptions:
1. Investors are rational, risk-averse and utility maximizing individuals.
2. Frictionless markets
3. All investors plan for the same holding period
4. Investors have homogenous expectations
5. Investors are infinitely divisible
6. Investors are price takers.
CAPM limitations:
● Only systematic risk are included
● Does not consider multi-period implications
Security market line (SML)
SML is a graphical representation of CAPM, which applies to all securities, whether they are efficient
or not.
Slope of the SML is market risk premium, E(Rm) – Rf
If an asset’s expected return forecast is higher (lower) than its CAPM required return, the asset is
undervalued (overvalued).
Other portfolio performance evaluation methods
Total risk Sharpe ratio E[ R portfolio ] –Rf /σ portfolio
Total risk M-squared (RP − Rf) σ M / σ M - (RM − Rf)
Systematic risk Treynor ratio RP− Rf / βP
Systematic risk Jensen’s alpha αP = Rp − [Rf + βP(RM − Rf)]
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Reading 54: Basics of Portfolio Planning and Construction
Investment policy statements (IPS)
IPS is a written document detailing the portfolio construction process designed to satisfy a client’s
investment objectives.
Major components of an IPS are:
● Introduction
● Statement of purpose
● Statement of duties and responsibilities
● Procedures
● Investment objectives
● Investment constraints
● Investment guidelines
● Evaluation of performance
● Appendices
Assessing overall risk tolerance
● Usually expressed as average, above average, below average.
● 2 factors affect investor’s overall risk tolerance:
o willingness (investor’s intent towards risk)
o ability to take risk (investor’s capability to take risk, independent of intent)
Investment constraints
Investment Description
constraints
Time horizon The longer the time horizon, the greater the ability to take risk and the lower
the liquidity needs.
Taxes Consider individual tax status, investment jurisdiction and tax treatment of
various types of investment accounts.
Liquidity Cash requirements varies by client and need to consider having a portion of
assets in liquid investments.
Legal / regulatory Consider if there are legal restrictions on investments or max percentage
allocation on certain assets.
Unique Usually individual constraints are present, such as avoid certain class of
circumstances security or industry, or ethical preferences etc.
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Reading 55: Introduction to Risk Management
Risk management framework
● Risk governance: a top-down process that defines risk tolerance and provides guidance to
align risk with company goals
● Risk identification and measurement
● Risk infrastructure
● Defined policies and processes
● Risk monitoring, mitigation and management
● Communications
● Strategic analysis or integration
Other risk definitions
● Risk tolerance: what risks are acceptable and how much risk should be taken
● Risk budgeting: how and where the risks are taken and quantifies tolerable risk by specific
metrics
● Financial risk: risks that originate from financial markets such as change in interest rates. 3
major types of financial risk are market risk, credit risk and liquidity risks.
● Non-financial risk: risks that arise from within an entity or externally. Examples of non-
financial risks are: operational risk, solvency risk, settlement risk, legal risk, regulatory,
accounting and tax risk, model risk, tail risk, political risk.
● Methods of risk measurements: standard deviation, beta, duration, delta, gamma, VaR,
CVaR, etc.
● Methods of risk modification: risk prevention/avoidance, risk acceptance (self-insurance
and diversification), risk transfer (insurance), risk shifting/modification (via derivatives).
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Reading 56: Technical Analysis
Technical analysis assumptions
● Supply and demand determine prices.
● Changes in supply and demand can cause changes in prices.
● Prices can be projected with charts and other technical tools.
● Investors are often irrational, hence preventing market efficiency.
Technical analysis tools
Charts
Line chart Simple graphical display of price trends over time.
Bar chart Shows open, close, low and high prices for each data point.
Candlestick Also shows open, close, low and high prices for each data point. White body means
chart closing price > opening price (i.e. Market closed higher), dark body means closing price
< opening price (i.e. Market closed lower).
Point and figure X means an increase in price whilst O means a decrease in price.
chart
Trend analysis
Uptrend Security prices are reaching higher highs and higher lows
Downtrend Security prices are reaching lower highs and lower lows
Support A price level where there is sufficient buying pressure to stop a further decline in prices.
Resistance A price level where there is sufficient selling pressure to stop a further increase in
prices.
Change in Once a support level is breached, it often becomes the new resistance level, and vice
polarity versa.
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Common chart patterns
Head and shoulders Consists of a left shoulder, head and right shoulder. This pattern indicates the
(H&S) pattern end of an uptrend.
Inverse head and This is a mirror image of the H&S pattern and indicates an upcoming uptrend
shoulders pattern following a preceding downtrend.
Double/triple tops Prices hit the same resistance level twice/thrice before falling down,
indicating the end of an uptrend.
Double/triple bottoms Prices bounces back from the same support level twice/thrice before going
up, indicating the end of a downtrend.
Reversal patterns (signalling the end of a trend):
Continuation patterns (signals a temporary pause in the trend):
Triangles One trend line connects the highs, another trend line connects the lows.
3 types:
– Ascending: Highs form a horizontal line, lows form uptrend.
– Descending: Lows form a horizontal line, highs form downtrend.
– Symmetrical: Highs from downtrend, lows form uptrend.
Rectangles Highs and lows form horizontal lines.
Flags Similar to rectangles, but parallel trend lines over a short period
Pennants Converging trend lines over a short period.
Rate of change (ROC) When ROC oscillator crosses 0 into the positive (negative) territory, it is
oscillator considered bullish (bearish).
Relative strength index (RSI)
Stochastic oscillator When %K line moves from below to above %D line, this is considered bullish.
Vice versa.
Moving average Consists of the MACD line and signal line:
convergence/divergence MACD line is the difference between 2 exponentially smoothed averages (12
oscillator (MACD) days and 26 days usually)
Signal line is the exponentially smoothed average of MACD line (9 days
usually)
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Technical indicators
Price-based indicators
Moving average Average closing price over a specified number of periods.
Bollinger bands Lines representing moving average and moving average +/- set number of
standard deviation from average price.
Momentum oscillators
Sentiment indicators
Opinion polls Regular polls gauging market sentiment
Put/call ratio Volume of puts traded divided by volume of calls traded. High ratio means
market is bearish.
CBOE volatility index A measure of near-term market volatility calculated from S&P 500 stock
(VIX) options. High VIX indicates when investors are fearful of a market decline.
Margin debt Loans taken out by investors to fund stock purchase. When margin debt is
increasing, investors are buying aggressively and this will drive up stock prices.
Short interest Number of shares sold short relative to daily trading volume. A high short
interest ratio indicates a negative outlook on the security.
Flow of funds indicators
Arms index Measures the relative extent to which money is moving into and out of rising
(or TRIN) and declining stocks.
– Value = 1 means market is in balance.
– Value above (below) 1 means there is more volume in declining (increasing)
stocks and the market is in selling (buying) mood.
Margin debt Margin loans may increase stock purchases and declining margin balances
may force stock sale.
Mutual fund cash % of mutual fund assets held in cash. During bullish (bearish) market, cash
position position tends to be low (high).
New equity issuance IPOs are often timed when market is bullish for best valuations.
Secondary offering Similar to IPOs, secondary offerings are monitored to gauge changes in
equities supply.
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Cycles
Kondratieff wave 54 year long economic cycles, known as the K wave.
18 year cycle Often associated with real estate and equities.
Decennial pattern Years ending in 5 have shown the best performance.
Presidential cycle The 3rd year following an election tends to show the best performance.
Elliott Wave Theory
This theory states that market moves in regular waves or cycles.
Market waves follow patterns that are ratios of the Fibonacci sequence
The Fibonacci sequence starts with the numbers 0, 1, 1, and each subsequent number in the
sequence is the sum of 2 preceding numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34 …
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Reading 57: Fintech in Investment Management
• Fintech refers to the technological innovation in the design and delivery of financial products
and services.
• Big data refers to a mix of structured and unstructured datasets that can come from a variety
of sources such as individuals, business processes and sensors.
• Artificial intelligence (AI) computer systems perform tasks that traditionally required human
intelligence. They display cognitive and decision-making ability comparable or superior to
humans. E.g. Apple’s Siri digital assistant.
• Machine learning (ML) is a computer-based technique that extracts knowledge and learns from
a large amount of dataset, then applying this pattern to generate predictions on another
dataset.
• 3 main approaches to ML:
• Supervised learning: inputs and outputs are identified and labelled.
• Unsupervised learning: inputs and outputs are not labelled. ML algorithm will seek or identify
the relationships by itself.
• Deep learning: neural networks are used by computers to perform multi-stage, non-linear data
processing to identify patterns and relationships.
• Fintech applications:
• robo-advisory services: low cost, automated advice process for investments
• risk analysis: monitoring risks in real time
• algorithmic trading: automated trading based on pre-specified rules
• Financial applications of distributed ledger technology (DLT):
• Cryptocurrencies
• Tokenization: the process of representing ownership rights to physical assets on a blockchain.
DLT can streamline this process of physical asset verification (e.g. real estate) by creating a
single digital record of ownership.
• Post-trade clearing and settlement: DLT can simplify the currently cumbersome post-trade
clearing and settlement process by providing near real-time trade verification, reconciliation
and settlement.
• Compliance: stricter regulatory reporting requirements have made the cost of compliance
higher. DLT can streamline the compliance process by providing near real-time access to
transaction and compliance data.
Behavioral Biases in Individuals.
In the context of portfolio management, recognizing behavioral biases can allow an adviser to
develop a deeper understanding of his clients
Behavioral Biases can be of two types
• Cognitive
• Emotional
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Cognitive Includes:
Belief preference, conservatism bias and processing errors
Emotional biases are as follows:
1. Loss-Aversion Bias
2. Overconfidence Bias
3. Self-Control Bias
4. Status Quo Bias
5. Endowment Bias
6. Regret-Aversion Bias
Different types of Market Anomalies
• Calendar effects
• Monday effects
• Turn of the month
• January effect
• Holiday effect
