16.0 Managing individual portfolios and institutional investors:

  • Individual investors: overview
    • Investor characteristics: situational profiling (source of wealth, measure of wealth, stage of life); psychological profiling (traditional finance, behavioural finance, personality typing)
    • Investment policy statement for an individual investor
    • Strategic asset allocation for an individual investor: Monte Carlo simulation in personal retirement planning

16.1.2   Institutional investors: overview

  • Pension funds: defined-benefit and defined-contribution plans; pension fund risk tolerance; defined benefit and defined contribution investment policy statement; risk management considerations; hybrid pension plans; employee share ownership plans
  • Other institutional investors: Foundations, endowments, Insurance industry (life and non-life insurance companies), banks, investment intermediaries and other institutional investors; their background and investment setting

16.2    Asset allocation

  • Overview of asset allocation: role of asset allocation in portfolio management; strategic versus tactical asset allocation; Importance of asset allocation in portfolio performance; Steps involved in establishing an appropriate asset allocation
  • Asset allocation and investors and return objectives: Dynamic versus static asset allocation; factors affecting asset allocation policy(loss aversion; mental accounting; fear of regret); Return and risk objectives in relation to asset allocation
  • Selection of asset classes: criteria for specifying asset classes; inclusion of international asset assets (developed and emerging markets)
  • Optimisation approaches to asset allocation: mean-variance approach ( Its application when adding an asset class in an existing portfolio); resampled efficient frontier; experience based approaches; asset only, asset/liability management (ALM); ); Black – Letterman; Monte- Carlo Simulation
  • Nondomestic equities and bonds: Their associated risks, costs and opportunities
  • Conditional return correlations: their importance when evaluating the diversification effects of nondomestic investments
  • Integrating a segmented market with a global market: expected effects on share prices expected returns, and return volatilities
  • Formulation and justification of minimum-variance frontier given investment policy statement and capital market expectations

16.3    Fixed income portfolio management

  • Use of liability as a benchmark and use of bond index as a benchmark with respect to investment objectives
  • Managing funds against a bond market: Classification of strategies ( Pure bond indexing/full replication approach, enhanced indexing and active investing, full-blown); selection of a benchmark bond index and factors to consider(market value risk, income risk, liability framework risk); Use of bond market indices
  • Techniques used to align the risk exposures of the portfolio with those of the benchmark bond index: duration matching technique, key rate durations technique
  • Assessment of the risk and return characteristics of a proposed trade: total return analysis, scenario analysis
  • Bond immunisation strategy: its formulation and evaluation under various interest rate scenarios
  • Spread duration and its importance
  • Extension of classical immunisation theory: introduction of contingent immunisation
  • Risks associated with managing a portfolio against a liability structure: interest rate risk, contingent claim risk, cap risk
  • Immunisation strategies for single liability, multiple liabilitiesand general cash flows: their advantages and disadvantages
  • Immunised portfolios: risk immunisation and return maximisation
  • Cash flow matching: its use in funding a fixed set of future liabilities; its advantages and disadvantages

16.4    Relative value methodologies for global credit bond portfolio management

  • Classic relative value analysis based on top down and bottom up approaches to credit bond portfolio management
  • Cyclical supply and demand changes: their implications in the primary bond markets; impact of secular changes in the markets dominant structures
  • Investors short term and long term liquidity needs: their influence on portfolio management decisions
  • Common rationale for secondary market trading
  • Corporate bond portfolio strategies

16.5    International and emerging market fixed-income portfolio management strategies

  • Effect of leverage on portfolio duration and investment returns
  • Use of repurchase agreements (repos) to finance bond purchases: Factors affecting the repo rate
  • Measures of fixed income portfolio risk: standard deviation, target semi variance, shortfall risk and value at risk (VaR)
  • Use of futures instead of cash market instruments to alter portfolio risk
  • Formulation and evaluation of an immunisation strategy based on interest rates
  • Use of interest rate swaps and options to alter portfolio cash flows and exposure to interest rate risk; use of credit derivative instruments to address default risk, credit spread risk and downgrade risk in the context of fixed income portfolio
  • Potential sources of excess return for an international bond portfolio
  • Effect of change in value for a foreign bond when domestic interest rates change, and the bond’s contribution to duration in domestic portfolio, given the duration of the foreign bond and the country beta
  • Hedging currency risk in international bond markets; break even spread analysis in seeking yield advantages across international bond market; investing in emerging market debt:
  • Criteria for selecting a fixed income manager

16.6   Equity portfolio management

  • Role of the equity in the overall portfolio
  • Equity investment approaches: passive approach; active approach; semi-active (enhanced- index ) approach; their relevance with respect to expected active return and tracking risk
  • Weighting schemes used in the construction of major equity market indices and the biases associated with each
  • Passive equity investing: alternative methods for establishing passive exposure to an equity market; indexed separate or pooled accounts, index mutual funds, exchange-traded funds, equity index futures and equity total return swaps
  • Approaches to  constructing  an indexed portfolio: full replication, stratified sampling and optimisation
  • Active equity investing: equity investment–styles classifications and risks associated with each; techniques for identifying investment styles; equity style indices; equity style box analysis and style drift; long–short and long-only investment strategies; ‘equitised’ market- neutral and short-extension portfolios; sell disciplines/trading of active investors
  • Semi-active equity investing (enhanced-index): derivatives-based and stock-based enhanced indexing strategies
  • Managing a portfolio of managers: core-satellite approach to portfolio construction; effect of adding a completeness fund to control overall risk exposures
  • Components of total active return (“true” active return and “misfit” active return) and their associated risk measures; alpha and beta separation as an approach to active management;
  • Identifying, selecting, and contracting with equity managers
  • Structuring equity research and security selection: top-down and bottom-up approaches to equity research

16.7    Alternative investments portfolio management

  • Introduction to alternative investments portfolio management
  • Selection of active managers of alternative investment scheme
  • Alternative investment benchmarks: construction and interpretation; benchmark bias
  • Return enhancement and risk diversification effects of adding an alternative investment to a reference portfolio(for instance a portfolio of bonds and equity only)
  • Venture capital: major issuers and suppliers; purpose of venture capital; buyout funds; use of convertible preferred stock in direct venture capital investment
  • Private equity fund: typical structure and timelines; formulating private equity investment strategy
  • Commodity investments: direct and indirect commodity investment; components of return for commodity futures contracts; role of commodities in a portfolio
  • Hedge funds: typical structure; high water- mark provisions; fund-of-funds; performance and evaluation
  • Managed futures: trading strategies; role in a portfolio
  • Distressed securities: risks associated with investing in distressed securities including event risk, market liquidity risk, ‘J-factor’ risk

16.8    Currency portfolio management

  • Effects of currency movements on portfolio risk and return
  • Strategic choices in portfolio management
  • Active currency trading strategies based on economic fundamentals, technical analysis, curry trade and volatility trading
  • Adjusting the hedge ratio using forward contracts and foreign exchange (FX) swaps
  • Trading strategies used to reduce hedging costs and modify the risk return characteristics of a foreign currency portfolio
  • Portfolios exposed to multiple foreign currencies: use of cross-hedges ratio, macro-hedges ratio, minimum-variance-hedge ratio
  • Challenges for managing emerging market currency exposures

16.9    Execution of portfolio decisions

  • The context of trading: market microstructure: order types and their price and execution uncertainties, their effective spread and their quoted bid ask spread ; types of markets and their quality; roles of brokers and dealers
  • Costs of trading: transaction costs components (explicit and implicit costs); implementation shortfall and volume weighted average price (VWAP) as measures of transaction costs; use of econometric methods/models in pre-trade analysis to estimate implicit transaction costs
  • Major types of traders: their motivation to trade, time versus price preferences and preferred order types; major trading tactics ;algorithmic trading strategies and determining factors including order size, average daily trading volume, bid–ask spread and the urgency of the order
  • Trade execution decision and tactics: meaning and criteria of best execution; firm’s investment and trading procedures, including processes, disclosures and record keeping with respect to best execution
  • Role of ethics in trading

16.10 Portfolio monitoring and rebalancing

  • Monitoring : fiduciary’s responsibilities in monitoring an investment portfolio; monitoring of investor circumstances, market/economic conditions and portfolio holdings; revisions to an investor’s investment policy statement and strategic asset allocation, given a change in investor circumstances
  • Rebalancing: benefits and costs of rebalancing a portfolio to the investor’s strategic asset allocation; calendar rebalancing; percentage-of-portfolio rebalancing; optimal corridor width of an asset class; target portfolio rebalancing versus allowed range portfolio rebalancing; rebalancing strategies (linear, concave, and convex rebalancing strategies); constant mix, buy-and-hold, and constant proportion portfolio insurance (CPPI) rebalancing strategies

16.11 Evaluating portfolio performance

  • Importance of performance evaluation from the perspective of fund sponsors and the perspective of investment managers
  • Components of performance evaluation: performance measurement, performance attribution and performance appraisal
  • Performance measurement: total, time-weighted, money-weighted rates of return, linked internal rate of return and annualized return
  • Benchmarks: concept of a benchmark; properties of a valid benchmark; types; steps involved in constructing a custom security-based benchmark; validity of using manager universes as benchmarks; tests of benchmark quality; hedge funds and hedge fund benchmarks
  • Performance attribution: inputs for micro and macro attribution; use of macro and micro performance attribution methodologies to identify the sources of investment performance; use of fundamental factor models in micro performance attribution
  • Performance appraisal: risk-adjusted performance measures, including (in their ex post forms) alpha, information ratio, Treynor measure, Sharpe ratio and Modigliani-Modiglian measure(M2 ) ;incorporation of portfolio’s alpha and beta into the information ratio, Treynor measure, and Sharpe ratio; use of performance quality control charts in performance appraisal
  • Practice of performance evaluation: noisiness of performance data; manager continuation policy decisions


 TOPIC                                                                                                              PAGE

  1. Managing individual portfolios and institutional investors ………9
  2. Asset allocation…………………………………..……………15
  3. Fixed income portfolio management……………………37
  4. Relative value methodologies for global credit bond portfolio management…..56
  5. International and emerging market fixed income portfolio management


  1. Equity portfolio management…………………………….…74
  2. Alternative investments portfolio management………91
  3. Currency portfolio management……………………………95
  4. Execution portfolio decisions………………………….……121
  5. Portfolio monitoring and rebalancing…………….…….134
  6. Evaluating portfolio performance…………………………141





What characteristics of individual investors distinguish them from other investors in ways that may affect the strategic asset allocation decision? Individual investors are taxable and must focus on after-tax returns. Tax status distinguishes individual investors from tax exempt investors (such as endowments) and even other taxable investors such as banks, which are often subject to different tax schedules than individual investors. Other, inherent rather than external, differences exist, however, asset allocation for individual investors must account for:

  • The part of wealth flowing from current and future labor income, and the charging mix of financial and labor-income-related wealth as a person ages and eventually retires.
  • Any correlation of current and future labor income with financial asset returns.
  • The possibility of outliving one’s resources.

Psychological factors may also play a role. Behavioral finance points to a variety of issues that individual investors and their advisers face when determining the asset allocation.

Human capital

An individual investor’s ability and willingness to bear risk depends on;

  1. Personality makeup
  2. Current and future needs
  3. Current and anticipated future financial situation, considering all sources of income.





Asset allocation (AA) is the process of deciding on how to distribute an investor’s wealth among different countries and asset classes for i9nvestment purposes. An asset class is comprised of securities that have similar characteristics, attributes and risk/return relationships. A broad asset class such as bonds can be divided into smaller asset classes such as T-bonds and asset bonds.

The AA decision is not an isolated choice rather it is a component of a structured 4-step portfolio management process. The process involves:

  1. Creating an investment policy statement-which is a road map that investors specify the type of risk they are willing to take and their investment goals and constraints. All investment decisions are based on quality statements to ensure these decisions are appropriate for the investor.
  2. Examine current and projected financial, economic, political and social conditions. Here the portfolio manager forecast future trends based on the current market conditions which will determine the investment strategy to be applied by the manager. Economies are dynamics and are affected by numerous industry struggles, politics and changing demographics as well as social attitudes.
  3. Construct the portfolio with the investor’s policy statement and financial market forecasts as inputs. The advisors implement the investment strategy and determine how to allocate portfolio across different countries, asset classes and securities.
  4. Continuous monitoring of the investor’s needs and capital market conditions and when necessary updating policy statements. This investment strategy is expected to be monitored effectively. An important component in monitoring process is to evaluate the portfolio’s performance and compare the relative





A Fixed income portfolio manager may manage funds against a bond market index or against the client’s liabilities. In the former approach, the chief concern is performance relative to a selected bond index in the latter its performance in funding the payment of liabilities. Managing funds against a bond market index will be covered later and will address other fixed income strategies relating to international bonds. The investment management process follows the following steps;

  1. Select the investment objectives against constraints
  2. Developing and implementing a portfolio strategy
  3. Portfolio monitoring
  4. Portfolio review

Using bond index as a benchmark

Bond fund managers are commonly compared to a benchmark that is selected or constructed to closely resemble the managed portfolio eg assume a bond manager specializes in one sector of the bond market instead of simply accepting the return generated by the manager, investors want to be able to determine whether the manager consistently earns sufficient returns to justify management expenses. In this case, a custom benchmark is constructed so that any difference in return is due to strategies employed by the manager, not structural differences between the portfolio and the benchmark.

Another manager might be compared to a well-diversified bond index. If the manager mostly agrees with the market forecasts and values s/he will follow a passive management approach.





In relative value analysis, assets are compared along readily identifiable characteristics and value measures. With bonds, some of the characteristics used include sector, issuer, duration, and structure, which are used to rank the bonds across and within categories by expected performance. You are familiar with two of these methodologies:

  1. In the top-down approach, the manager uses economy-wide projections to first allocate funds to different countries or currencies. The analyst then determines what industries or sectors are expected to outperform and selects individual securities within those industries.
  2. The bottom-up approach starts at the bottom. The analyst selects undervalued issues.

Classic relative-value analysis combines the best bond investment opportunities using both the top-down and bottom-up approaches. The methodology combines many sources of information from portfolio managers, quantitative analysts, credit analysts, economists, strategists, and CEOs.

Any bond analysis should focus on total return. The analyst performs a detailed study of how past total returns for markets or individual securities were affected by macroeconomic events, such as interest rate changes and general economic performance.






Leverage refers to use of borrowed funds to purchase a portion of securities in a portfolio. Its use affects both the return and duration of a portfolio.

Leverage effects

If return earned on investment is greater than financing cost of borrowed funds. Return to investor will be favorably affected.

Leverage is beneficial when strategy earns a return greater than the cost of borrowing. Although leverage can increase return, it also has a downside. If the strategy return falls below cost of borrowing, the loss to investments will be increased.


A portfolio manager has a portfolio worth 100M, 30M of which is her own funds and 70M is borrowed. If the return on invested funds is 5%. Calculate return on the portfolio.


Return on overall fund = 100m x 6%=6m

5%x 70m=3.5m which is cost of debt





Equities are substantial portion of investment universe and US equity typically constitutes about half of the world’s equity. An inflation hedge is an asset where nominal returns are positively correlated with correlation. Bonds have a poor inflation hedge because their future cash flows are fixed which makes their value decrease with increased inflation.

This drop in price reduces or eliminates return for current bonds holders.

The historical evidence in the US and other countries that equities have been a good inflations hedge. There are some important qualifiers however. First because corporate and capital gains tax rates reduce stock investors returns unless this effect was priced into the stock when the investor bought it.

Second, the ability of an individual stock to hedge inflation will depend on its industry competitive position, the greater the competition, the less likely the firm will be able to pass inflation to its consumers.


Passive equity managers do not use forecast to influence investment strategies, most commonly implementation of passive management is indexing. This is where a management invests so as to mimic the performance of a security index.

Though indexing is passive in the sense that the manager does not try to outperform index The execution of indexing requires that managers buy securities weights increases in the index eg the security is added to index or the firm sells new stock.

Active equity management is the other extreme of portfolio management where managers buy, sell and hold securities in an attempt to outperform the benchmark





AIs offer diversification benefits and potential for active management. More modern AIs include Hedge funds, PE, commodities, structured products and real assets.

Features of AIs

  1. Low liquidity
  2. Diversification- They generally have low correlation with and offer significant diversification to traditional stocks and bond portfolios
  3. Difficult performance evaluation
  4. The lack of unique futures and lack of transparency of AIs make it difficult to identify appropriate valuation benchmark.

Due Diligence Check points

  1. Asses the market opportunity offered. Are there exploitable efficiencies in the market for the type of investment. Does the manager specialize in those strategies.
  2. Assess the investment process. What is the manager’s competitive edge over others
  3. Assess the people. Are they qualified with high moral character or competence
  4. Assess the organization. Is it stable and well run.


Special issues that AIs raise for investment advisors

1.taxes – Most individuals must pay taxes and many AIs are structured as limited partnerships which require special tax expertise.





In addition to the risk associated to uncertain future value of investment, foreign investing also exposes the investor to translation risk. The risk associated with exchanging the foreign currency back into the investor’s domestic currency.


Assume a US investor makes a 90-day Euro denominated investment valued at £ 1M. the spot exchange rate is $ 1.2888/£, so the US investor must invest (1.2888x1M = 1,288,800) in 90 days, the spot rate changes to $ 1.2760/£ and the investment is valued at 1,050,000. When the investment is liquidated and translated back into US dollar, the investor receives (1,050,000×1.2760)= 1,339,800.

The return on the investment in the local currency (Europe) is

(1,050,000-1,000,000)/1,000,000 and the return in the dollars is 3.96% (1,339,800-1,288,800)/1,288,800

The total return on the portfolio which includes the asset and futures contract is





Market micro structure refers to the structure and processes of a market that may affect the pricing of the securities in relation to intrinsic value and the ability of managers to execute trade.

The micro structure of the market and objectives of manager should affect the type of order the manager uses. Two major types of orders:

Market order-order to execute market immediately at the best possible price. If the order cannot be completely filled by one trade, its filled by other trades at the best possible price. The emphasis on this is the price and speed of execution.

A limit order-is an order to trade at the limit price or better. For a sale order, the execution price must be higher than or equal to the limit price. If prices do not move within the limit, the trade will not be completed so it has execution uncertainty.


The bid price is the price a dealer will pay for a security, and the bid quantity is the amount a dealer will buy of a security.

The ask/offer price is the price at which a dealer will sell a security and ask quantity is the amount a dealer will sell off her security. Ask-bid=bid ask spread which is the dealer’s compensation.

The prices a dealer offers are limit orders because they specify the price at which they will transact. The dealers thus have a limit order book.





The focus of this topic review is how to adjust for changes in client circumstances, capital market conditions and value of portfolio holdings in the period after initial calculations have been made.

The rebalancing strategies that will be looked at include buy and hold, constant mix and constant proportion portfolio insurance. (CPPI).


A portfolio manager who is position of trust has a responsibility to monitor the portfolio and ensure it meets client’s objectives with changing market conditions and expectations the portfolio holdings should be reviewed in line with the IPS. Changes in client circumstances may require an update in IPS changes in capital market conditions which may lead to changes in SAA. This may require rebalancing.

Monitoring of investor circumstances, market conditions and portfolio holdings

Over time, investor circumstances may change and portfolio managers must take account of these changes. Advisors may need to update the IPS for the investor whenever there are significant changes in the investor risk and return objectives, time horizon, tax, liquidity and legal changes. Changes in an investor’s IPS will reflect changes in these objectives and constraints. Essentially this involves constructing a new IPS that reflects these changes and perhaps the SAA for the portfolio as well even in the absence in significant changes in an investment circumstances changing capital market conditions may requiring altering investment asset allocation. These changes may lead to a revised expected return and risk attitudes requiring updating




Portfolio performance

It improves the effectiveness of a fund’s investment policy by acting as a feedback and control mechanism.

It does the following:

  1. It shows where the policy and allocation is effective and where it is not.
  2. Directs management to areas of value added and value lost
  3. It quantities the results of active management and other policy decisions.
  4. It indicates whether other additional strategies can be successfully applied.

Components of performance evaluation

  1. Performance measurement- to calculate rates of return based on changes in the account’s value over specified time period.
  2. Performance attribution – to determine the sources of account’s performance
  3. Performance appraisal – draw conclusions regarding whether performance was affected primarily by investment decisions, by overall market or by chance.

Return calculations with external CFs. The rate of return on an account is the percentage change in the accounts market value over a defined time period. An account’s rate of return needs to factor in external CFs. External CFs refers to contributions and withdrawals made to and from an account as opposed to internal CFs eg interests or dividends. If there is an external CF at the beginning of the evaluation period, the accounts return is calculated as follows:




Portfolio performance

It improves the effectiveness of a fund’s investment policy by acting as a feedback and control mechanism.

It does the following:

  1. It shows where the policy and allocation is effective and where it is not.
  2. Directs management to areas of value added and value lost
  3. It quantities the results of active management and other policy decisions.
  4. It indicates whether other additional strategies can be successfully applied.

Components of performance evaluation

  1. Performance measurement- to calculate rates of return based on changes in the account’s value over specified time period.
  2. Performance attribution – to determine the sources of account’s performance
  3. Performance appraisal – draw conclusions regarding whether performance was affected primarily by investment decisions, by overall market or by chance.

Return calculations with external CFs. The rate of return on an account is the percentage change in the accounts market value over a defined time period. An account’s rate of return needs to factor in external CFs. External CFs refers to contributions and withdrawals made to and from an account as opposed to internal CFs eg interests or dividends. If there is an external CF at the beginning of the evaluation period, the accounts return is calculated as follows:


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