CIFA Intermediate Level

Portfolio Management flashcards

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Complete Flashcard Reference

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What are the three steps of the portfolio management process, and what happens in each?

Planning: understand the client's needs and objectives, then prepare the investment policy statement (objectives, constraints, strategic asset allocation). Execution: asset allocation, security analysis and portfolio construction. Feedback: monitoring and rebalancing, and performance measurement and reporting, which loops back into planning.

What is the CAPM required return, and what does it say is priced?

Required return = Rf + beta x (Rm - Rf). Only systematic risk, measured by beta, is priced, because unsystematic risk can be diversified away at no cost. Example: Rf 12%, Rm 18%, beta 1.4 gives 12% + 1.4 x 6% = 20.4%.

How does the capital market line differ from the security market line?

CML: expected return against total risk (standard deviation); applies only to efficient portfolios, combinations of the risk-free asset and the market portfolio. SML: expected return against systematic risk (beta); applies to every individual asset or portfolio, efficient or not.

What is the difference between ability and willingness to bear risk, and which wins when they conflict?

Ability (capacity): an objective measure of how much risk the client can afford, from wealth, income stability, time horizon and liabilities. Willingness: the client's own psychological comfort with risk and volatility. Where they diverge, follow the more conservative of the two: abandoning a plan in a downturn usually does more damage than a moderately lower expected return.

State the fundamental law of active management.

IR ~ IC x sqrt(BR). IC, the information coefficient: the correlation between the manager's forecasts and actual outcomes. BR, breadth: the number of independent investment decisions made per year. Example: IC 0.05 and 100 decisions gives 0.05 x 10 = 0.50.

How are the Sharpe and Treynor ratios calculated, and when is each used?

Sharpe = (portfolio return - risk-free rate) / standard deviation: excess return per unit of total risk, for an investor's entire portfolio. Treynor = (portfolio return - risk-free rate) / beta: excess return per unit of systematic risk, for one portfolio among several held by an already-diversified investor.

What does value at risk state, and how is analytical (parametric) VaR calculated?

VaR: at a given confidence level and over a given horizon, the maximum loss a portfolio is not expected to exceed under normal market conditions. Analytical VaR = portfolio value x z x standard deviation (z = 1.65 for one-tailed 95%). Example: KES 50 million x 1.65 x 1.5% = KES 1,237,500 for one day at 95%.

How does time-weighted return differ from money-weighted return, and which judges the manager?

Time-weighted return compounds the return in each sub-period, removing the effect of the size and timing of client cash flows. Money-weighted return is an internal rate of return on the actual cash flows, so it reflects the investor's own timing. Time-weighted return judges the manager, who does not control when clients add or withdraw money.

What is the disposition effect?

The tendency to sell winning positions too early, to lock in a gain, and to hold losing positions too long, hoping to avoid realising a loss. Disciplined rebalancing rules can be built into portfolio construction to counteract it.

What is the difference between core capital and excess capital?

Core capital: what the client needs to fund their own lifetime spending and goals with a high degree of confidence. It should not be put at risk through lifetime gifting. Excess capital: wealth beyond core capital, which can be transferred during the client's lifetime without jeopardising their security, often more tax-efficiently than waiting until death.

What does a portfolio perspective mean?