Investment management in an evolving and volatile World

LESSON 1: WHAT KIND OF INVESTORS ARE YOU?

SIMPLEST MEASURE OF RISK
 VARIANCE: The variance is a measure of dispersion of returns around expected
return. 
 As risk-averse investors, we prefer investments with lower variance
 LESSON 2:
US or Swiss investors, have counter-cyclical or safe haven currencies, which tends to increase in
value when mkt plummet.They will be more eager to hedge their currency exposures.
Variance and volatility are measures of risk for a single asset or a single portfolio.
If all assets in a portfolio tend to plunge at the same time, the portfolio is more risky than if they
tend to move in opposite direction. 
We can measure comovement risk using covariance, which is defined as the expected value of
the product of two returns' deviation from their own expected return.
(Formula in my note)

A positive covariance indicates both assets, A and B, tend to be above their expected return at
the same time, whereas a negative covariance indicates that when one asset has a high return,
the other tends to have a low return.

Correlation varies between minus one and plus one. 

A positive value indicates that asset returns tend to move in the same direction and vice versa.

INVESTABLE ASSETS:

Asset class is simply a group of similar type of financial instruments. 

A financial instrument or financial asset, is a claim against an underlying asset. 
The underlying asset could be an entity like a company or government, or a real asset, which is
an asset in physical form, like a land or building, equipment.

In the asset universe we count four broad categories of asset classes : 

- Money market or cash equivalence. 
- Fixed income, which are primarily bonds, 
- Equities, which are also called stocks. 
- And alternative assets, a broad category, including real estate, commodities and private equity.

The main characteristic of this asset class, is that the cash flows received by the investor are set
in advance. Failure to pay these cash flows usually entails the issuer's bankruptcy. 
The issuance price of a bond is typically set at par, which is the face value paid at maturity.

The actual market price of a bond depends on a number of factors including the credit quality of
the issuer, the maturity and the coupon rate, which can be variable or fixed, and is compared to
the general interest rate environment at the time.

Those with the higher credit ratings called investment grade bonds, and those having a higher
risk of default but also a higher expected yield, named the high yield bonds.

What is a claim? Let's take an example. 

By purchasing equity, an investor becomes an owner in a corporation. 
Ownership comes with voting rights and the right to share in any future profits.
By purchasing debt, an investor becomes a creditor to the firm or government. 
Being a creditor gives you a higher claim on assets than shareholders do. That is, in the case of
bankruptcy, a bond holder will get paid before a shareholder.

The bond holder does not share in the profits if a company does well, he is entitled only to the
principal plus interest.

FINANCIAL MARKET PARTICIPANTS

Supranational entities are large issuers of debt. The term supranational refers to a group of two
or more central governments that promote economic development for 
the member countries. 
Some well-known examples of supranational institutions are the World Bank, the European
Investment Bank, the Asian Development Bank and the Inter-American Development Bank.

The old stock exchange on Wall Street is an iconic example of a marketplace but open outcry
systems such as these have one disappeared and been replaced by computers. Financial markets
are now dematerialized. Transactions can be executed directly on electronic platforms or on the
phone through recorded lines.

Data and information providers such as Bloomberg and Reuters deliver real time flows of
financial data and news. These providers give investment professionals the 
tools that are used to follow the markets and monitor transactions.

Benchmark providers such as S&P, Russell and MSCI make independent calculations of the main
market benchmarks according to precise methodologies. These benchmarks are used as a
reference for the performance of the investments.

Clearing houses are independent organizations in charge of reconciling and matching the market
risks between participants while aggregating margin calls to reduce the 
overall risk taken by all market participants.

Proxy voters provide recommendations or vote on behalf of equity fund managers in relation to
corporate decisions. 

Local regulators such as the AMF in France, SEC in the US and the FCA in the IK can enquire
about transactions. They also require a huge amount of data from all asset 
management companies to monitor their activities. Today, regulators face significant challenges
in relation to activities and transactions where technology is playing a stronger role. 
A good example is the Flash Crash in 2010 involving high frequency trading where both, the SEC
and CFTC were the regulators in charge.
WEEK 2:

A mutual fund or a hedge fund manager can be interested by his performance in excess of his
benchmark. He therefore aims at maximising his added value for a 
given risk of deviating from his benchmark. 
A pension fund, or insurance company, can be interested by its performance in excess of the value
of its liabilities. It will aim at maximising expected return on assets, while minimising the risk of
having a shortfall with respect to its liabilities.

The most common type of constraints is those on portfolio weights. 

An ineligibility constraint, on some assets, can be used to define your investment universe. Your
ability to achieve the highest trade-off between your portfolio expected return and variance
risk, naturally depends on which type of securities you can create. 

Another possible constraint is a no short sell constraint. The weight of an asset has to be

positive. You can also set a lower and upper limit on an asset weight in a portfolio. 
This type of constraint can be used to limit the allocation deviation from the weight in a
benchmark portfolio. 
For example, the weight of a sector in your portfolio can be set to plus or minus ten percent, its
weight in your benchmark.

Constraints on weights are not the only type. Another useful type is those on portfolio risk. 
For example, you can set a maximum level of portfolio volatility or a maximum amount of
tracking error, which is the volatility of your return differential with a benchmark index.
There are different reasons to impose constraints on your portfolio allocations. In all cases,
portfolio constraints are used to set hard limits on what could happen in the worst cases. 
After all, an allocation of a hundred percent to a very risky stock may appear optimal before the
facts. But it is a little consolation if the company goes bankrupt and you lose all your money.

Covariance is a measure of the co-movement between two assets. A positive value means that
they tend to move together, whereas a negative value indicates that on average, when 
one goes up, the other goes down.
Lower correlation decreases the variance of our stock-bond combination, and a trade-off between 
reward and risk is more interesting.

THE IMP OF ASSET PRICING IN PORTFOLIO MGT

By using this model, we integrate some economic foundation in our portfolio management
approach, instead of simply estimating the expected returns as free parameters.
We can estimate the average return of known factors and the betas of an asset to these factors, in
order to obtain the asset expected return.

In the most basic setup, called the capital asset pricing model or CAPM, the market portfolio Fm,
in which all assets are weighted by their market capitalisation, arises naturally as the only source
of positive average returns. 
There are no mispricings nor other risk factors. 
According to this model, the market portfolio is the only factor, and only the differences in
exposure to the market factor explain the differences in expected returns across portfolios.

LESSON 2
STRATEGIC VS TACTICAL ALLOCATION
 Strategic asset allocation (SAA) is a long-term asset allocation, that is expected to provide
the required risk and return for a portfolio over the long run, with infrequent rebalancing
and readjustments.
 In this case, asset risk and return profile is considered through a whole business cycle, and
the investment horizon is generally around 8 to 10 years and beyond.
 On the other hand, tactical asset allocation is a process of deviating from the long term
SAA, with the aim of enhancing performance over the short term.
 the investment horizon here is about a year, 3 to 6 months, or even shorter

The economic cycle has 4 main stages. Slow down, recession, recovery, and expansion.
And it's often measured by the output gap, which is the difference between potential output of
the economy and its current output, or potential GDP and actual GDP. We also look at the
economic growth rate. 
And different stages correspond to different levels of the output gap and the economic growth
rate. For example, a recession will be characterised by a negative output gap, and a slow or
negative growth rate.

 In a slow-down, equities and bonds typically perform poorly, as inflations and interest

rates rise, growth tends to slow down, and corporate profitability is impacted. 
 In a recession, there are weakening corporate profits, equities typically perform poorly
and bonds will perform well at first. Corporate bonds generally underperform
government bonds in this scenario.
 In a recovery, monetary policy is accommodative. Growth is strengthening and
inflation is low, and equities typically perform well, and corporate bonds outperform
government bonds.
 In expansion, unemployment is falling, there's job creation and spending
on infrastructure, and here real estate assets are attractive.

In essence, TAA aims to take advantage of the time variation in expected return, which could
be caused by time varying risk premia, inefficiencies, or both, and hence take advantage of
the attractiveness of securities in different asset classes. We also aim to take advantage of
short-term market opportunities, as well as manage and mitigate shorter term risks, to
improve the overall performance of the portfolio.
*TAA relies on forecasting skills: Technical analysis, fundamental analysis, and quantitative
analysis.
1. Technical analysis:
assumes that all historical data is already incorporated into asset pricing, technical analysis
aims to forecast the direction of prices through the study of historical market data, in
particular looking at prices and volumes of trading.
Technical analysts often use charts, to try to identify patterns and market trends in order to
forecast prices, and they're often called chartists because of this.

2. Fundamental analysis
where the focus is on analysing the fundamentals, such as the state of the economy,
interest rates, inflation, corporate earnings, and monetary policy.
 3. Quantitative analysis,
involves forecasting market direction using quantitative methods, statistical models,
mathematical formulas and algorithms. A common approach is to use multifactor models.
Multifactor models are financial models that employ multiple factors in calculating and
explaining asset prices, like the CAPM
Another use of multifactor models is helping portfolio managers understand the risk
allocation within their portfolio.
Risk factor analysis is the process of identifying and measuring the different risk factors
within the asset classes, and then combining them across a multi-asset portfolio to analyse
how the risk is distributed. 

The simplest asset pricing model was the capital asset pricing model, in which the only risk
factor is the market portfolio that contains all assets
That’s because, The aggregate portfolio of all investors is the market factor, the central piece
of the capital asset pricing model. We collectively own the market and our
collective performance is therefore equal to the performance of the market portfolio.

HEDGING TECHNIQUES: HOW TO PROTECT PORTFOLIO AGAINST

UNDESIRED RISK?
Hedging techniques often, but not always, use financial instruments called derivatives. 
Derivatives are financial contracts that derive their value from an underlying asset, or
portfolio of assets.

A put option gives the holder the right to sell a specified quantity of the underlying equity
stock or index, at an agreed price, called the strike price, at a future date called the expiry
date, in exchange of the payment of a premium. 
The put option payoff at expiry is a positive difference between the strike and the underlying
price at such time, and the P&L is the payoff minus the initial premium paid.
CASE 1: EQUITY PROTECTION
Investors willing to hedge a diversified equity portfolio would generally use a market index
as underlying, to benefit from higher liquidity compared to a customised portfolio, provided
the correlation between index and portfolio is sufficient.
To hedge its portfolio against severe loss scenarios, investor would generally buy an out-of-
the-money put option, with the strike being fairly below the underlying index price; such
strike being the level of protection at maturity. The more out-of-the-money the option is, the
lower the cost.
On the other side, a put option is said to be “in-the-money” when the strike is above the
underlying price, meaning that option payoff would be positive if it would mature at the
considered date; such positive value being called intrinsic value.
There are 3 main drivers of an option value. 
First, underlying index price: An equity put option appreciates as its underlying price 
is falling, and its price sensitivity to a given percentage fall, which is called the delta of the
option, is also increasing in the downside. 
In other words the protection effect is getting higher as the losses mount on the underlying,
which is called the convexity effect.

A vanilla option has a positive time value, which is decreasing as time passes.
An out-of-the-money put option value will converge to zero at maturity, assuming
markets are stable. Which means that to be permanently hedged, investors have to buy new
options from time to time.

The third driver of option value is the volatility of the underlying price. 
An option value appreciates as its underlying price volatility increases, because of the higher
expected payoff. This can add to the protection effect of a put option, as generally volatility
spikes when markets are stressed.

As the investor's equity portfolio decreases in value, the put option will generally increase in
value, and therefore partially mitigate portfolio losses. 

CASE: CURRENCY RISK

The forward exchange rate depends on the spot exchange rate and the spread between interest
rates of the two currencies.
A cureency forward allows one to buy or sell currency at a predetermined exchange rate.
DRIVERS OF OPTION VALUE
 Underlying index price
 Time to expiry
 Volatility of underlying price

FX Forward is an agreement to buy currency A against currency B on a future date at a fixed

exchange rate.

WEEK3:
THE ECONOMICS OF ACTIVE MGT:
The market is divided into two types of investors, passive and active. 
Passive investors hold a portfolio that mimics the market portfolio. That is, they place the
same proportion in each asset as their proportion in the market portfolio

Passive investing does not cost much. You do not have to do any research on different
companies to make a decision on your allocation. All you have to do is to replicate the
market's allocation. Plenty of low cost index funds and exchange traded funds do exactly this.

The second type of investors are active. Being an active investor means that you adopt a
portfolio allocation that is different from the market portfolio.
Active investors, by gathering information about different investments in order to make
proper allocation decisions, choose how capital is allocated in a society. Efficient capital
allocation is crucial to economic development because it determines which projects get
funded and at what cost. 
ACTIVE MGT DISCRETIONARY APPROACH:
The discretionary approach in active management. 
A quantitative approach in active management relies on a systematic approach.
Now we will focus on the judgmental approach, which relies much more on a fund manager's
own expertise, together with the views from macro- and micro-analysts. 

Sometimes quantitative models cannot be used to make investment decisions. A pure

quantitative approach has limits. 
For example, when a new company enters the equity market through an IPO, there is no
historical data to feed a quantitative model, to tell us whether or not to include 
that stock in a portfolio.
Another example is that destructive technology can drastically change a sector's dynamics. 
Let's think how digital camera has totally transformed the photo industry in a few years' time,
and even destroyed a huge company like Kodak.

What is an investment process?

It starts with a general assessment of the economic environment, and ends with the portfolio
and its day-to-day life, the monitoring of its strategies and risks.
One of the first objectives is the assessment of both top-down and bottom-up factors.

Top-down factors can be monetary policy, led by central banks, that will have an impact on a
country, but also on the country's trading partners, through currency and global trade
dynamics.
Geopolitical dynamics can have a widespread impact on the domestic equity markets.
Environmental events can also have impact on markets. 

The bottom-up factors can be merger and acquisition activity, that will have a direct impact
on the companies involved, both on their debt and their equity. 
Another bottom-up factor can be something very specific to a company, for example a
destructive technology, like the launch of a new product in the sector, or a product being in
the early stage in the product cycle, such as when a new medicine is introduced in the
pharmaceutical industry
So, one way to look at an asset class and to summarize the impact of both top-down and
bottom-up elements, is to use the MVST method, that looks at macro, valuation, sentiment,
and technical factors. 

On the macro side, we have listed here the data that have the most influence on markets. 
Some of those, like the NFP, nonfarm payroll, can sometimes create strong market
movements, as they are considered, for good or bad reasons, as a good indicator of the labor
market in the US, and by extension indicate whether US growth is likely to accelerate or
decelerate.

Sentiment is a difficult concept to measure, but can sometimes be the driving factor for a
specific market, for a given period of time. The risk aversion can be measured through
volatility indices like the VIX index which is the index of volatility implied by option prices.

So these high risk aversion phases will have a positive impact on the high rated government
bond markets and a negative impact on the equity market in general.

INVESTMENT MGT DECISIONS:

Portfolio construction plays thus a major role in the implementation of investment
management decisions.
Not all investors use quantitative allocation methodologies. Sometimes they may not be
feasible at all.
Sometimes they  rely on a naive approach: in terms of portfolio construction, you can indeed 
decide to hold an equally weighted portfolio. 

HOW TO MANAGE TRADING EFFICIENTLY

Let's describe the different types of markets where you can find 2 large categories: organized
vs. over-the-counter markets.
First, in organized markets counterparties do not trade directly with each other. Their buy
orders, called bid, and sell orders, called ask or offer, are openly disclosed to market
participants. 
Equity markets are typically order-driven markets; only authorized members can trade and
transfer their own clients ‘orders, under the supervision of the operator and the regulator. 
Technology has entirely changed the landscape of organized markets over the past 2 decades,
with the arrival of electronic trading platforms.
In over-the-counter or OTC markets, transactions are negotiated directly between 2 market
participants. Fixed-income forex commodities and OTC derivatives markets are typically
quote-driven markets.
They are less formal, although often well-organized networks of trading. 
Dealers will not quote the same price to all other dealers, and that will depend on the size of
the transaction, the quality of the counterparty. 
Moreover, dealers in an OTC security can withdraw from market-making at any time, which
can cause liquidity to dry up, disrupting the ability of market participants to buy or sell.

When a company issues for the first time a security, either debt or equity, this company is
coming to the primary market; either through auction or syndication for that instrument, or
through an initial public offering, or IPO, for stocks. 
Usually, banks work alongside the issuer in order to set the relevant price, according to the
market environment, the peers, the rating. Usually, there's a premium for investors to buy
these newly-issued securities. 

Then these securities can be bought or sold on financial markets - this is what we call the
secondary market.
The quotes on the secondary markets are expressed in terms of bids and offers. 
The bid offer spread, represents the difference between the buy and sell price of a given
security.

So let's talk about trading costs now.

Trading costs can be explicit. These are the commissions paid to a broker, or a bank, for
example. It can be taxes paid to a local regulator. You also need to take into account the fees
paid to register into a trading platform, and the clearing and settlement fees. These costs are
easy to measure. 

Implicit costs are harder to appreciate.  As we've seen, bid and offer prices depend on the size
of a transaction: the larger the size, the more a transaction is going to have an influence in the
final price.
When asset managers have to execute large sizes in specific markets, they will then try to
optimize their impact on the market.
HOW TO MANAGE EXTREME EVENTS IN FINANCIAL MKT?

TAIL RISK: These are important, because even though they happen very 
rarely, they have a high and persistent impact on portfolios. 

The reason why tail risks happen, is that asset returns do not follow a nice, symmetric,
normal distribution.

In real life, they exhibit skewness and fat tails.

 
Skewness measures how asymmetrically returns are distributed. Negative skewness, implies
that large and negative returns are more likely than large and positive returns, and vice-versa.
Fat tails indicate the likelihood of extreme returns, regardless of their size.
So to make things a bit more formal we usually define a tail event as an asset price move by
more than 3 units of volatility. 

It is equally important to position ahead of such events, to recognize the increase in

correlations between assets during crisis periods, and to make decisions after the events.

INCORPORATE TAIL RISK IN PORTFOLIO CONSTRUCTION:

1st part:
 Use a portfolio preference metric
 Take tail risk into account in addition to volatility
 Limit maximum drawdowns
 Opportunity cost
 Lose little money in normal times but make lot of money in stresses period by
benefiting from the rise in volatility
 Use of derivatives as an insurance
 Look for assets with asymmetric correlation patterns

The final way would just be to use a purely discretionary approach in active management,
meaning that you trust yourself that you will be able to recognize a tail event as it occurs, and
avoid its most negative impact. 
In the end, this is what most investors do, although many may not be aware of their
vulnerability to extreme events.
WEEK 4
Formalise your investment objective:
Collective investment schemes, or pool funds allow several investors to pool their
investments together.
Some investors may have a concentration ratio limit for pooled vehicles due to liquidity
affairs, meaning they can only invest up to a certain percentage of the total fund. 
It can be more cost efficient to invest in a pooled vehicle, where extra costs such as custody
and administration fees are born by all the investors and not one single investor in the case of
a segregated vehicle.

Investment managers use several fee structures, the basic two being a straight fixed fee and a
performance-based fee.
A fixed fee, surprisingly enough, is a fixed rate, typically given as a percentage or number of
basis points of the amount invested over a given period.
Performance fees will usually mean a lower fixed fee, plus additional fees rewarding a
manager's outperformance. 
Performance fees often include additional caveats to provide an incentive to the manager or
to limit the amount paid by the investor.
These can include hurdle rates, whereby a manager has to achieve a minimum level of that
performance before being paid performance fees.

Fixed fees are the most common. But, performance fees can importantly insure an alignment
of interest between the investor and the invest manager.

Enhanced indicators are increasingly used, again, linked to heightened regulatory

requirements imposed on our clients. For example, solvency two for insurance companies. 

For segregated accounts, Investment objectives are formalised in “Investment Mgt

Agreement”
LESSON 2:
PROFESSIONALS AT WORK IN AN ASSET MGT COMPANY:

PRODUCT CYCLES IN ASSET MGT

We can split the funds by category, into passive and active funds. Passive funds focus on
delivering performance as close to the benchmark performance as possible. They do not try to
incorporate research, or other active investment decisions. 
Active funds will try to beat the market, or a certain predefined market rate.

Analyzing the market demand is typically the first stage of this process.
Once the decision to create the product is made, the necessary legal documentation is put in
place. This includes the investment guidelines and other important contractual information.
Finally, the registration of the fund is carried out with local regulators, before starting active
promotion of the product.

STEPS TO LAUNCH A PRODUCT:

1. A market and competitive analysis with the result that we see ideally high demand and a
low number of competitors. 
2.The analysis of the depth of the investment universe. This step takes around 2 months. Note
that these 2 steps I cite here, can be overlapping and do not necessarily need to happen one
after the other.
3.Step 3, is the analysis of the target clients, to check whether the fund is well-positioned.
4.Another step is the search for seed money, either from clients or from within the
company. It takes up to 6 months to find the seed investors.
5.As a step 5, we create the fund prospectus. We apply for the regulatory approval and the
registration in the selected countries for distribution.