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CFA Level Book Study online at quizlet.com/_2as2gz Account Return if External Cash Flow at Beginning of Evaluation Period Formula 2.Account Return if External Cash Flow at End of Evaluation Period Formula Algorithmic Trading The use of automated, quantitative systems that utilize trading rules, benchmarks, and constraints to execute (4 Types) orders with minimal risk and costs Classified into: Simple logical participation - seek to trade with market flow so as to not become overly noticeable to the market and to minimize market impact Breaks trade into small pieces and trades throughout the day; small part of trading volume and low market impact costs (narrow spread, low urgency, and small relative average daily volume) Implementation Shortfall (arrival price strategies) - minimize trading costs defined by the implementation shortfall measure or total execution costs Trade heavier early in the day to ensure order completion, reduce opportunity costs, and minimize the volatility of trading costs Executes order quickly to Minimize variance of cost of trading Similar to portfolio optimization because portfolio value is maximized (high urgency level) Opportunistic Participation - trade passively over time but increase trading when liquidity is present Specialize strategies include passive strategies and other misc strategies Allocation/Selection (Portfolio Weight of Sector - Benchmark Weight of Sector) * (Portfolio Return on Sector - Benchmark Return of Interaction = Sector) Appropriate ways to monitor performance for Long-Short Hedge Funds 1.Value Added Return (performance impact) Separate long/short benchmarks and then combine them to their relevant proportions to create an overall benchmark Sharpe Ratio - compares to risk free return rather than benchmark it is possible for MV0 to be zero for a long-short portfolio, making return calc nonsensical Best Execution Characteristics Depends on value added of the trade versus cost Best execution and value added cannot be known ex ante Best execution and cost can only be calculated ex post Assessing value added may take even longer to evaluate if the idea works out Relationships and practices are integral to best execution Best execution is ongoing and requires diligence and dedication to the process compared to prudence (selecting most appropriate securities for an investor) whereas best execution refers to best means to buy/sell those securities Briefly explain the challenges inherent in performance measurement and performance evaluation for a long-short hedge fund If traditional performance measurement and evaluation are not appropriate in a long-short environment, are there other options that may be useful? Brokered Markets: Investors use brokers to locate counterparty to trade Useful when trader has large block to sell, wants to be anonymous, or when security market is small or illiquid Buy and Hold (BH) Characteristics and Risk Tolerance -Exposure diagram's slope is equal to one -Does not rebalance regardless of portfolio wealth level -Investor's tolerance for risk is zero if the value of the investor's assets falls below the floor value -Otherwise, passively, risk tolerance increases proportionately with wealth 10 Buy Side and Sell Side Relationship Both sides must follow word of honor or no one will take opposite trade Two reasons that have increase opportunity and temptation to act unethically between each other are: The development of electronic trading provides more anonymity a trader who gains information from another can use this info against the other Decline of explicit brokerage commissions, can lead to greater implicit costs Buy side should always act in best interests of their clients and have duty to maximize their portfolio and never put sell-side traders before them 11 CFA Institute Trade Management Guidelines Processes - firms should have procedures in place to maximize value using best execution Disclosures - provide disclosures to clients and potential regarding information on trading techniques, markets, brokers and conflicts of interest Record Keeping - maintain documentation supporting firm's compliance and disclosures sent to clients Retains as evidence to regulators as best execution for clients 12 Client Circumstances that may cause portfolio rebalance Change in Wealth Change in Time Horizon Change in liquidity Requirements Tax Concerns Laws and Regulations Unique Circumstances/Preferences 13 Compare and contrast macroBoth macro attribution and micro attribution are different facets of performance attribution The attribution with micro attribution basic tenet behind performance attribution is that an account's performance is compared to a What is the difference between designated benchmark, then the sources of differential returns are identified and quantified The using a return metric and using a main difference between macro and micro attribution is the definition of which "account's" dollar metric? Briefly discuss the performance we are analyzing Macro attribution is done at the fund sponsor level; that is, inputs and methodology that analysis is typically done for a grouping of investment managers or investment accounts Micro could be used with a macro attribution is carried out at the level of the individual investment manager analysis There are three main inputs to the macro attribution approach: policy allocations; benchmark portfolio returns; and fund returns, valuations, and external cash flows Fund sponsors determine policy allocations, or "normal" weightings, for each asset class and individual manager These are typically determined after some sort of asset liability analysis and/or determination of the risk tolerance of the governing body of the fund Benchmark portfolio returns are an important factor in determining the value added by the fund If the benchmarks not adequately match the managers' investment styles, the performance attribution will have little value Fund sponsors may use broad market indexes as the benchmarks for asset categories (the Wilshire 5000 as the benchmark for overall US domestic equities, for example) and may use more focused indexes to represent managers' investment styles (such as the Russell 2000 Value Index for a small-cap value manager) Fund returns, valuations, and external cash flows are all critical elements for determining the relevant performance for the portfolio as a whole and for each individual investment manager's account A return metric implies that fund returns are used at the level of the individual management account to allow an analysis of the fund sponsor's decisions regarding manager selection A dollar-metric approach uses account valuation and external cash flow data to calculate rates of return and also to compute the dollar impacts of the fund sponsor's investment policy decision making 14 Composites must include new timely and consistent basis after each portfolio comes under management portfolios on a 15 Constant Mix (CM) Characteristics Concave represents the sale of portfolio insurance and Risk Tolerance -Exposure diagram's slope is less than one -Any procedure that buys when stocks fall or sells when stocks rise is a concave strategy -If more investors follow concave strategies, the markets will become too stable -Absolute Risk tolerance varies directly with wealth -Relative risk tolerance remains constant regardless of wealth level -Investors using this strategy will hold stocks at all levels of wealth 16 Constant Proportion PortfolioConvex represents the purchase of portfolio insurance Insurance (CPPI) Characteristics-Exposure diagram's slope is greater than one and Risk Tolerance -Any Procedure that buys when stocks rise or sells when stocks fall is a convex strategy -The more investors follow convex strategies, the more volatile the markets will become -Investor risk tolerance is similar to that of the BH Methodology -Investor Risk tolerance drops to zero when total assets drop below the floor value -However, CPPI assumes that investor risk tolerance is more dramatically affected by changes in wealth levels than BH 17 Constructing Multifactor models to conduct Micro Attributions / Returns based style analysis Identify the fundamental factors that will generate systemic returns Determine the exposures of the portfolio and the benchmark to the fundamental factors at the start of the evaluation period Determine the manager's active exposure to each factor Determine the active impact this is the added return due to the manager's active exposures Fundamental factor model micro attribution results will look very similar to returns based analysis (returns are regressed against the returns to several different indices to determine factor exposures) The primary difference between them is the use of other fundamental factors (leverage, market timing, sector rotation, size of the firm) that would not be used in returns based style analysis 18 Construction of Customer Security Based Benchmark steps Identify important elements of investment process Select securities consistent Weight the securities (including cash) to reflect manager's process Review and adjust as needed to replicate Rebalance custom benchmark on predetermined schedule 19 Criteria of Market should provide Liquidity, Transparency, and assurity of completion Quality Liquid markets have small bid ask spreads, market depth, and resilience Transparent markets allow investors to obtain pre trade (regarding quotes/spreads) and post trade information (completed trades) Assurity of completion in markets let investors be confident that the counterparty will uphold its side of the trade agreement Lquidity can be measured by quantitative measurements, while transparency and assurity of completion are qualitative assessments Lower quoted and effective spreads and higher bid and ask sizes indicate greater liquidity and quality 20 Crossing Networksshould not disclose unmatched quantities Maintain complete confidentiality not only in regard to the size of the orders and the names of the investors placing the orders, but also in regard to the unmatched quantities If a crossing network were to disclose the unmatched quantities, it would provide useful information to other parties that would affect the supply and demand of these stocks in which clients want to transact As a result of the information leakage, transaction costs for its clients would likely rise 21 Crossing System or Broker should be used when a trade is relatively large and has large spread in attempt to minimize spread (large volume) calculate spread by (Ask - Bid)/Last Price 22 Determinants Transaction Costs (higher the costs means greater optimal width of corridor) (illiquid assets mean wider corridor bc higher costs to minimize transaction costs, corridor should be higher = less rebalance;less transaction costs Risk tolerance (higher tolerance, wider optimal corridor) Correlation of returns with other asset classes (greater correlation, wider optimal corridor) Volatility of asset class returns (greater volatility, narrower optimal corridor) Volatility of returns on other assets in portfolio (greater volatility, narrower optimal corridor widths) 23 Determining Compare the market capitalizations between the subject portfolio and respective benchmark index (median, average, weighted average) of Optimal Corridor Width in Percentage of Portfolio Rebalancing Program Appropriateness of an Index as the Benchmark to Portfolio Compare the portfolio beta to the potential benchmark/index 24 Econometric Models can be used ex ante and ex post by Ex Ante - determining size of the trade Ex Post - trading effectiveness can be assessed by comparing actual trading costs to forecasted trading costs from the models Help forecast transaction costs and show they are nonlinearly related to: Security liquidity - trading volume, market cap, spread, and price Size of the trade relative to liquidity Trading Style - more aggressive trading results in higher costs Momentum - trades that require liquidity Risk 25 Effective and Quoted Spreads would be equal if a purchase took place at the ask price or a sale took place at the bid price 26 Effective Spread (Buy Order) = x (execution price - midquote) 27 Effective Spread (Sell Order) = x (midquote - execution price) 28 Estimated Implicit CostsTrade size × (Trade price - Benchmark price) for a buy Trade size × (Benchmark price - Trade price) for a sale 29 Ex Post Alpha uses SML as benchmark (also uses CAPM for Expected Return on Account) ; systematic risk 30 Four Management Factors Interest Rate Management Effect: ability to predict changes in relevant interest rates contributing to a fixed-2 Sector/Quality Effect: Ability to select and overweight (underweight) outperforming income Portfolio's Return:(underperforming) sectors and qualities Security selection effect: ability to select superior securities to represent sectors Trading Activity: residual effect; assume to measure the return to active trading (buying and selling) over the period 31 Four Types of Trader: Information Motivated traders - trade based on time sensitive information; prefer market orders because their trades must take place quickly Their trades demand liquidity, and they are willing to bear the higher trading costs Liquidity motivated traders - transact to convert their securities to cash or reallocate their portfolio from cash They utilize market orders and trades on crossing networks and electronic communication networks (ECNs) Liquidity motivated traders prefer to execute their within a day Value-motivated traders - use investment research to uncover misvalued securities They will use limit orders because price, not speed, is their main objective Passive traders - trade for index funds They favor limit orders and trades on crossing networks This allows for low commissions, low market impact, price uncertainty, and possible elimination of the bid ask spread 32 GIPS Valuation Hierarchy 33 Hybrid Quoted Prices from an active market for the same or a similar security Quoted prices from an inactive market for the same or a similar security 3.Observable market-based inputs other than quoted prices Subjective, unobservable inputs Combination of either Quote driven, Order driven, or brokered markets Market: 34 Impact of Strategies on Risk and Return for BH, CM, and CPPI 35 Implementation Shortfall Missed Trade (opportunity/unrealized profit or loss) = |CP - DP| * # of shares canceled Components Explicit Costs (commission/fees) = cost per share * # of shares executed Delay (slippage) = |BP` - DP| * # of shares later executed BP` = revised benchmark price Market Impact (price impact/realized profit or loss) = |EP - DP or BP`| * # of shares executed BP* if there is a delay 36 Implementation Shortfall Benchmark is Quoted Price Midpoint Estimate Sums of each of the [# of shares * (Benchmark - Cost of Order) For the number of times issues were purchased 37 Implementation Shortfall (IS) measures transaction costs as the difference in performance of a hypothetical portfolio in which the trade is fully executed with no cost and the performance of the actual portfolio For a Purchase: - an increase in price is a cost A decrease in price is an account benefit (negative cost) For a Sale: - an increase in price is an account benefit (negative cost) A decrease in price is a cost Disadvantages: may be unfamiliar to traders; Requires considerable data and analysis 38 Implementatio n Shortfall Key Terms Decision Price (DP) - Market Price of security when order is initiated Often orders are initiated when market is closed and the previous trading day's closing price is used as DP Execution Price (EP) - Prices at which the order is executed Revised Benchmark Price (BP*) - market price of security if the order is not completed in a timely manner as defined by the user Cancellation Price (CP) - market price of security if the order is not fully executed and the remaining portion of the order is canceled 39 Information Ratio 40 Jenson Alpha 41 M^2 Measure Total Risk (SD) measures value added/lost relative to the market if the portfolio had same risk as the market 42 Macro Attribution Analysis carried at the Fund Sponsor Level and uses a value metric that uses account valuation and external cash flow data to calculate rates of return and dollar impacts Three Inputs: 1.Policy Allocations Benchmark Portfolio Returns Fund Returns, valuations, and external cash flows 43 Market Order vs Limit Order Market Order - execute the trade immediately to get best possible price emphasis on speed of execution Has Price uncertainty Limit Order - order to trade at limit price or better can expire emphasis on price of execution Has execution uncertainty 44 Median Account As impossible to identify median manager in advance Benchmark Ambiguous Drawbacks Benchmark is not investable Impossible to verify appropriateness Have to rely on compiler's representations that the accounts have been screened, input data validated, and calculation methodology approved Survivor Bias, the median will be biased upwards 45 Micro Attribution Analysis carried out at investment manager level (attribute performance of an individual manager) Uses a rate of return metric that calculates percentage returns at the level of the individual manager account Three Inputs: Pure Sector Allocation Allocation selection Within-sector selection 46 Model performance cannot claim compliance if model performance is linked to actual performance vs Actual Performance The GIPS standards state that composites must include only actual assets under management within the defined firm, and they expressly prohibit linking the performance of simulated or model portfolios with actual performance 47 Modified Dietz Method Formula 48 Money Weighted Rate of Return Formula 49 One Factor Model ap = zero factor value Bp = beta R1 = Return on Market Index Ep = error term 50 Order Driven Markets:Investors trade with each other without the use of intermediaries Three Main Types: 1.Electronic Crossing Network (orders batched together and crossed (matched) at fixed points in time during the day at the average of the bid/ask quotes Auction Markets (trader orders compete for execution) Automated Auctions (computerized auction markets and provide price discovery 51 Original Dietz Method TWRR Formula 52 Portfolio Return P Formula (broken into returns due to Market, Style, and Active Management 53 Pure Sector Allocation = 54 Quote Driven Markets: 55 Seven Primary Types of Benchmarks in use: 56 (Portfolio Weight of Sector - Benchmark Weight of Sector) * (Benchmark Return of Sector - Return on Portfolio Benchmark) Investors trade with Dealers Absolute Manager Universe Broad Market Indices Style Indices Factor-Model Based Returns-Based Custom Security-Based Sharpe Ratio Total Risk (standard deviation) plotted against the CML 57 Switching portfolios to another composite Portfolios must not be switched from one composite to another unless documented changes to a portfolio's investment mandate, objective, or strategy or the redefinition of the composite makes it appropriate The historical performance of the portfolio must remain with the original composite 58 Terminated Portfolios must be last full measurement period that each portfolio was under management included in the historical performance of the composite up to the 59 Time Weighted Vs Money Weighted Return TWRR advantages: not influenced by external cash flow activity; appropriate when managers have little control over external cash activity TWRR Disadvantages: Account valuations needed for every date of external cash flow Admin Costs may be higher because of this MWRR Advantages: appropriate if mgr has control on external cash flows; valuations only needed at start and beg of period MWRR Disadvantages: sensitive to size/timing of external cash flows Not appropriate if mgr has no control on cash flows 60 Trader andPrincipal and Agent Broke acts as trader's agent and locates liquidity necessary at best price Broker may even take Broker position in security to facilitate trade Trader identity remain anonymous Broker also may provide record keeping, financing, cash management, and other services Relationship: 61 Trader andhave opposing interests dealers want to maximize trade spread while traders want to minimize it When trader has Dealer info that dealer doesn't have, trader profits at dealer's expense, which leads to adverse risk for the dealer It is the Relationship: trader's interest to conceal intent, while it is dealer's interest to find out who informed traders are 62 Trading "the actual costs of buying or selling investments" Expenses "These costs typically take the form of brokerage commissions, exchange fees and/ or taxes, and/ or bid-offer spreads from either internal or external brokers Custodial fees charged per transaction should be considered custody fees and not trading expenses." 63 (5) Trading Tacts Liquidity-at-any-cost Trading: trader must transact a large block of shares quickly Mutual fund that must liquidity shares quickly to satisfy redemption in its fund Trader ready to pay high price due to market impact, commissions, or both Costs-are-not-important Trading: trader believes exchange markets will operate fairly and efficiently such that the execution price they transact at is at best execution Market orders Need-trustworthy-agent Trading: trader employs broker to skillfully execute a large trade in a security, which may be thinly traded The weakness of this strategy is that commissions may be high and the trader may reveal his trade intentions to the broker Advertise-to-draw-liquidity: trade is publicized in advance to draw counterparties to the trade The weakness of this strategy is that another trader may front run the trade, buy in advance of a buy order Low-cost-whatever-the-liquidity: trader places a limit order outside of the current bid-ask quotes in order to minimize trading costs Passive and value-motivated traders will often purse this strategy 64 Tr eynor Measure Related to alpha by using beta ; systematic risk 65 Type I Error Rejecting the null hypothesis when it is true Keeping managers who are returning no value added 66 Type II Failing to reject the null when it is false Error Firing good managers who are adding value A Valid1 Specified in Advance Benchmark Appropriate Measurable Should Unambiguous meet the Reflective of Current Investment Opinions following Accountable Criteria: Investable 67 S-A-M-U-R-A-I 68 Vol ume Weighted Average Price (VWAP) weighted average of execution prices during a day where the weight applied is the proportion of the day's trading volume Best suited for an order that is a low percentage of the average daily volume of the stock Shortcomings: not useful if trader is significant part of trading volume because the activity will significantly affect the VWAP, trader is essentially comparing trades to herself Potential to "game" the comparison - trader could wait until late in the day and then decide which trades to execute Does not consider missed trades 69 What are One of the problems in estimating missed trade opportunity cost is that the estimate depends upon when the cost is some of the measured As the solutions to Parts A and B of this problem indicate, the estimate could vary substantially when a problems in different interval is used to measure the missed trade opportunity cost Another problem in estimating the missed trade estimating opportunity cost is that it does not consider the impact of order size on prices For example, the estimates above the missed assume that if the investment manager had bought the 500,000 shares on February, he would have been able to sell trade these 500,000 shares at $23.60 each on February (or at $21.74 each on 14 February) However, an order to sell opportunity 500,000 shares on February (or on 14 February) would have likely led to a decline in price, and the entire order of cost? 500,000 shares would not have been sold at $23.60 (or at $21.74) Thus, the missed trade opportunity costs above are likely to be overestimates 70 Within Sector Allocation = (Benchmark Weight of Sector) * (Portfolio Return on Sector - Benchmark Return of Sector)  ... spread 32 GIPS Valuation Hierarchy 33 Hybrid Quoted Prices from an active market for the same or a similar security Quoted prices from an inactive market for the same or a similar security 3. Observable... wealth -Relative risk tolerance remains constant regardless of wealth level -Investors using this strategy will hold stocks at all levels of wealth 16 Constant Proportion PortfolioConvex represents... either Quote driven, Order driven, or brokered markets Market: 34 Impact of Strategies on Risk and Return for BH, CM, and CPPI 35 Implementation Shortfall Missed Trade (opportunity/unrealized