CIFA Advanced Level

Advanced Portfolio Management flashcards

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Complete Flashcard Reference

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How is a one-year expected return for a bond built, rather than averaged?

E(R) = YTM + rolldown return - (modified duration x change in yield) - (PD x LGD). Example: yield 12.0%, rolldown 0.4%, duration 4.5, yields up 0.5%, PD 2%, LGD 60%: 12.0% + 0.4% - 2.25% - 1.2% = 8.95%. Each component is a stated assumption that can be challenged on its own.

What is human capital, and why does it let a young investor hold more equity?

Human capital is the present value of future labour income. Early in a career it is large and, with a secure salary, bond-like, so total wealth is already weighted to a bond-like asset and the financial portfolio can carry more equity. Close to retirement little human capital is left, so the financial portfolio must itself carry the lower risk.

What problem does the Black-Litterman approach solve, and how?

Mean-variance optimisation is extremely sensitive to noisy expected-return inputs, giving extreme, poorly diversified weights. Black-Litterman starts from the equilibrium returns implied by market capitalisation weights under the CAPM, then blends in the investor's own views where they have them, giving more intuitive, better-diversified allocations.

How does classical immunisation protect a single liability, and what are its limits?

Set the portfolio's Macaulay duration equal to the horizon, so a fall in price from higher yields is offset by higher reinvestment income on coupons, and the reverse. It holds only for a single, immediate, parallel shift, so the portfolio must be rebalanced as time passes and yields move.

How is a manager's total active return split into true and misfit active return?

True active return = portfolio return - manager's normal (style) benchmark: the skill. Misfit active return = normal benchmark - sponsor's policy benchmark: an artefact of benchmark mismatch. Example: 15% portfolio, 12% normal, 10% policy gives true 3%, misfit 2%, total 5%.

Why can reported returns overstate the diversification benefit of real estate or private equity?

Their returns are appraisal-based and smoothed, so reported volatility and correlation understate the true figures. In the guide's example a fund looks risk-reducing at 18% volatility and 0.3 correlation, but at de-smoothed figures of 28% and 0.6 the combined portfolio becomes riskier than before. Apply the caution before allocating.

How is a foreign asset's return converted into the investor's home currency?

R_DC = (1 + R_FC) x (1 + R_FX) - 1. Example: local return 12%, foreign currency up 5% against the shilling: 1.12 x 1.05 - 1 = 17.6%. The effects compound, so simple addition (17%) misses the cross-product.

What are the three components of implementation shortfall?

Execution cost = (average execution price - decision price) x shares executed. Opportunity cost = (closing price - decision price) x shares not executed. Explicit costs = commissions, fees and taxes. The common error is leaving out the opportunity cost on the unfilled shares.

How do constant mix and CPPI respond to market moves, and when does each do best?

Constant mix sells strength and buys weakness (concave payoff): best in volatile, range-bound markets. CPPI buys strength and sells weakness (convex payoff): best in strongly trending markets. Both underperform buy-and-hold in a flat market with little volatility.

What is the M2 measure and why is it popular with clients?

M2 = Rf + Sharpe ratio x benchmark standard deviation: the portfolio's return scaled to the benchmark's risk. Example: 16% return, 22% volatility, benchmark 12% and 15%, Rf 8%: Sharpe 0.3636, M2 = 8% + 5.45% = 13.45%, above 12%. It is a return, not a ratio, so it is easier to explain.

Why is capital market forecasting hard, for reasons that are structural rather than a matter of effort?