CFA 2018 exam level 3 level 3 wiley study guide vol 5

Reading 7: Behavioral Finance and Investment Processes 165Lesson 1:The Uses and Limitations of Classifying Investors into Types 165Lesson 2: How Behavioral Factors Affect Advisor-Client

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About the Authors xi

Wiley Study Guide for 2018 Level III CFA Exam

Volume 1: Ethical and Professional Standards & Behavioral Finance

Study Session 1: Code of Ethics and Standards of Professional Conduct

Reading 1: Code of Ethics and Standards of Professional Conduct 3

Lesson 1: Code of Ethics and Standards of Professional Conduct 3

Lesson 2: Standard II: Integrity of Capital Markets 36

Lesson 3: Standard III: Duties to Clients 46

Lesson 4: Standard IV: Duties to Employers 70

Lesson 5: Standard V: Investment Analysis, Recommendations, and Actions 84

Lesson 6: Standard VI: Conflicts of Interest 97

Lesson 7: Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate 107

Study Session 2: Ethical and Professional Standards in Practice

Reading 3: Application of the Code and Standards 119

Lesson 1: Ethical and Professional Standards in Practice, Part 1: The Consultant 119

Lesson 2: Ethical and Professional Standards in Practice, Part 2: Pearl Investment

Management 120

Reading 4: Asset Manager Code of Professional Conduct 121

Lesson 1: Asset Manager Code of Professional Conduct 121

Study Session 3: Behavioral Finance

Reading 5: The Behavioral Finance Perspective 131

Lesson 1: Behavioral versus Traditional Perspectives 131

Lesson 3: Perspectives on Market Behavior and Portfolio Construction 140

Reading 6: The Behavioral Biases of Individuals 147

Lesson 3: Investment Policy and Asset Allocation 159

Reading 7: Behavioral Finance and Investment Processes 165

Lesson 1:The Uses and Limitations of Classifying Investors into Types 165Lesson 2: How Behavioral Factors Affect Advisor-Client Relations 168Lesson 3: How Behavioral Factors Affect Portfolio Construction 169Lesson 4: Behavioral Finance and Analyst Forecasts 172Lesson 5: How Behavioral Factors Affect Committee Decision Making 178Lesson 6: How Behavioral Finance Influences Market Behavior 179

Wiley Study Guide for 2018 Level III CFA Exam Volume 2: Private Wealth Management & Institutional Investors Study Session 4: Private Wealth Management (1)

Reading 8: Managing Individual Investor Portfolios 3

Lesson 1: Investor Characteristics: Situational and Psychological Profiling 3Lesson 2: Individual IPS: Return Objective Calculation 6Lesson 3: Individual IPS: Risk Objective 7Lesson 4: Individual IPS: The Five Constraints 8

Lesson 6: Asset Allocation Concepts: The Process of Elimination 18Lesson 7: Monte Carlo Simulation and Personal Retirement Planning 20Reading 9: Taxes and Private Wealth Management in a Global Context 21

Lesson 1: Overview of Global Income Tax Structures 21Lesson 2: After-Tax Accumulations and Returns forTaxable Accounts 23Lesson 3: Types of Investment Accounts and Taxes and Investment Risk 31Lesson 4: Implications for Wealth Management 34Reading 10: Domestic Estate Planning: Some Basic Concepts 39

Lesson 1: Basic Estate Planning Concepts 39Lesson 2: Core Capital and Excess Capital 42

Lesson 5: Cross-Border Estate Planning 53

Study Session 5: Private Wealth Management (2)

Reading 11: Concentrated Single-Asset Positions 59

Lesson 1: Concentrated Single-Asset Positions: Overview and Investment Risks 59Lesson 2: General Principles of Managing Concentrated Single-Asset Positions 60Lesson 3: Managing the Risk of Concentrated Single-Stock Positions 66Lesson 4: Managing the Risk of Private Business Equity 71Lesson 5: Managing the Risk of Investment in Real Estate 74

Lesson 1: Human Capital and Financial Capital 77Lesson 2: Seven Financial Stages of Life 78Lesson 3: A Framework for Individual Risk Management 80

Lesson 7: Implementation of Risk Management for Individuals 95

Study Session 6: Portfilio Management for Institutional Investors

Reading 13: Managing Institutional Investor Portfolios 103

Lesson 1: Institutional IPS: Defined Benefit (DB) Pension Plans 103

Lesson 2: Institutional IPS: Foundations 111

Lesson 3: Institutional IPS: Endowments 115

Lesson 4: Institutional IPS: Life Insurance and 117

Non-Life Insurance Companies (Property and Casualty)

Wiley Study Guide for 2018 Level III CFA Exam

Volume 3: Economic Analysis, Asset Allocation, Equity & Fixed Income Portfolio Management

Study Session 7: Applications of Economic Analysis to Portfolio Management

Lesson 1: Organizing the Task: Framework and Challenges 3

Lesson 2: Tools for Formulating Capital Market Expectations, Part 1: Formal Tools 8

Lesson 3: Tools for Formulating Capital Market Expectations, Part 2: Survey and

Panel Methods and Judgment 13

Lesson 4: Economic Analysis, Part 1: Introduction and Business Cycle Analysis 19

Lesson 5: Economic Analysis, Part 2: Economic Growth Trends, Exogenous Shocks, and

Lesson 6: Economic Analysis, Part 3: Economic Forecasting 30

Lesson 7: Economic Analysis, Part 4: Asset Class Returns and Foreign Exchange Forecasting 33

Lesson 1: Estimating a Justified P/E Ratio and Top-Down and Bottom-Up Forecasting 39

Study Session 8: Asset Allocation and Related Decisions in Portfolio Management (1)

Reading 16: Introduction to Asset Allocation 53

Lesson 1: Asset Allocation in the Portfolio Construction Process 53

Lesson 2: The Economic Balance Sheet and Asset Allocation 54

Lesson 3: Approaches to Asset Allocation 55

Lesson 6: Strategic Considerations for Rebalancing 65

Lesson 1: The Traditional Mean-Variance Optimization (MVO) Approach 67

Lesson 2: Monte Carlo Simulation and Risk Budgeting 70

Lesson 3: Factor-Based Asset Allocation 71

Lesson 4: Liability-Relative Asset Allocation 72

Lesson 5: Goal-Based Asset Allocation, Heuristics, Other Approaches to Asset Allocation,

Study Session 9: Asset Allocation and Related Decisions in Portfolio Management (2)

Reading 18: Asset Allocation with Real-World Constraints 81

Lesson 1: Constraints in Asset Allocation 81

Lesson 2: Asset Allocation for the Taxable Investor 84

Lesson 3: Altering or Deviating from the Policy Portfolio 85Lesson 4: Behavioral Biases in Asset Allocation 87Reading 19: Currency Management: An Introduction 89

Lesson 1: Review of Foreign Exchange Concepts 89Lesson 2: Currency Risk and Portfolio Return and Risk 95Lesson 3: Currency Management: Strategic Decisions 98Lesson 4: Currency Management: Tactical Decisions 101Lesson 5: Tools of Currency Management 104Lesson 6: Currency Management for Emerging Market Currencies 112

Lesson 1: Distinguishing between a Benchmark and a Market Index and

Lesson 2: Market Index Uses and Types 117Lesson 3: Index Weighting Schemes: Advantages and Disadvantages 119

Study Session 10: Fixed-Income Portfolio Management (1)

Reading 21: Introduction to Fixed-Income Portfolio Management 127

Lesson 1: Roles of Fixed Income Securities in Portfolios 127

Lesson 4: Components of Fixed Income Return 135

Lesson 6: Fixed Income Portfolio Taxation 140Reading 22: Liability-Driven and Index-Based Strategies 143

Lesson 2: Managing Single and Multiple Liabilities 144Lesson 3: Risks in Managing a Liability Structure 147Lesson 4: Liability Bond Indexes 148Lesson 5: Alternative Passive Bond Investing 148

Study Session 11: Fixed-Income Portfolio Management (2)

Lesson 1: Foundational Concepts for Yield Curve Management 153

Lesson 3: Formulating a Portfolio Postioning Strategy for a Given Market View 161Lesson 4: A Framework for Evaluating Yield Curve Trades 167Reading 24: Fixed-Income Active Management: Credit Strategies 169

Lesson 1: Investment-Grade and High-Yield Corporate Bond Portfolios 169

Lesson 4: Liquidity Risk and Tail Risk in Credit Portfolios 185Lesson 5: International Credit Portfolios 189Lesson 6: Structured Financial Instruments 191

Study Session 12: Equity Portfolio Management

Reading 25: Equity Portfolio Management 197

Lesson 1:The Role of the Equity Portfoli and Approaches to Equity Investing 197

Lesson 4: Semiactive Equity Investing 215

Lesson 5: Managing a Portfolio of Managers 218

Lesson 6: Identifying, Selecting, and Contracting with Equity Portfolio Managers 222

Wiley Study Guide for 2018 Level III CFA Exam

Volume 4: Alternative Investments, Risk Management, & Derivatives

Study Session 13: Alternative Investments for Portfolio Management

Reading 26: Alternative Investments for Portfolio Management 3

Lesson 1: Alternative Investments: Definitions, Similarities, and Contrasts 3

Lesson 3: Private Equity/Venture Capital 9

Study Session 14: Risk Management

Reading 27: Risk Management 39

Lesson 1: Risk Management as a Process and Risk Governance 39

Lesson 3: Measuring Risk: Value at Risk (VaR) 44

Lesson 4: Measuring Risk: VaR Extensions and Stress Testing 52

Study Session 15: Risk Management Applications of Derivatives

Reading 28: Risk Management Applications of Forward and Futures Strategies 65

Lesson 1: Strategies and Applications for Managing Equity Market Risk 65

Lesson 2: Asset Allocation with Futures 74

Lesson 3: Strategies and Applications for Managing Foreign Currency Risk 83

Reading 29: Risk Management Applications of Option Strategies 89

Lesson 1: Options Strategies for Equity Portfolios 89

Lesson 2: Interest Rate Option Strategies 103

Lesson 3: Option Portfolio Risk Management Strategies 116

Reading 30: Risk Management Applications of Swap Strategies 121

Lesson 1: Strategies and Applications for Managing Interest Rate Risk 121

Lesson 2: Strategies and Applications for Managing Exchange Rate Risk 137

Lesson 3: Strategies and Applications for Managing Equity Market Risk 148

Lesson 4: Strategies and Applications Using Swaptions 153

Wiley Study Guide for 2018 Level III CFA Exam Volume 5: Trading, Monitoring and Rebalancing, Performance Evaluation,

& Global Investment Performance Standards Study Session 16: Trading, Monitoring, and Rebalancing

Lesson 1: The Context of Trading: Market Microstructure 3

Lesson 3:Types ofTraders and Their Preferred OrderTypes 15Lesson 4: Trade Execution Decisions and Tactics and Serving the Client's Interests 17

Lesson 1: Monitoring for IPS Changes (Individual and Institutional) 25

Lesson 3: The Perold-Sharpe Analysis of Rebalancing Strategies 35

Study Session 17: Performance Evaluation

Reading 33: Evaluating Portfolio Performance 41

Lesson 3: Performance Attribution (4 Models) 55

Lesson 5: The Practice of Performance Evaluation 71

Study Session 18: Global Investment Performance Standards

Reading 34: Overview of the Global Investment Performance Standards 75

Lesson 1: Background of the GIPS Standards 75

Lesson 4: Return Calculation Methodologies 79Lesson 5: Composite Construction Lesson 85Lesson 6: Disclosure, Presentation, and Reporting 89Lesson 7: Real Estate, Private Equity, and Wrap Fee/Separately Managed Accounts 96Lesson 8: Valuation Principles and Advertising Guidelines 102Lesson 9: Verification and Other Issues 104

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a n d R e b a l a n c in g

Re a d in g 3 1: Ex ec u t io n o f Po r t f o l io Dec isio n s

Time to complete: 1.5 to 2.5 hours

Reading summary: Trading requires balancing execution timing against both direct and

indirect trade costs Be able to calculate and explain these costs Be able to explain how

different types of markets function, the kinds of trades that work best in those markets, and

trader motivations that lead them to various types of trades

INTRODUCTION

Wealth advisors wish to manage their client portfolios effectively, but at low cost Toward

that end, they may use portfolio managers who in turn use buy-side traders These trades

are charged with making error-free executions quickly and at costs favorable to the firm’s

clients Portfolio managers must communicate effectively with traders, as well as measure

and evaluate their executions Portfolio managers are therefore required to have some

familiarity with the mechanics of trading

This lesson will provide you with the tools to understand:

1 Market structure, quality, and participants;

2 Measures of trading and transactions costs, and their calculation;

3 Trading personalities, strategies, and algorithms; and

4 Best execution, its criteria, and procedures for its assurance

LESSON 1: THE CONTEXT OF TRADING: MARKET MICROSTRUCTURE

MARKET MICROSTRUCTURE

Market microstructure describes processes that traders use to translate the portfolio

manager’s decisions into executed trades Traders with accurate microstructure information

can formulate more effective and efficient strategies, and helps portfolio managers

understand why execution price varies from their value estimates For example, a need for

quick execution may require that traders accept a higher purchase or lower sale price

LOS 31a: Compare market orders with limit orders, including the price

and execution uncertainty of each Vol 6, pp 7-9

Order Types

Market orders emphasize a need for executing orders quickly at the best price available,

which implies price uncertainty For example, in a market with 3,000 shares available at

$24 and 8,000 shares available at $24.25, an order for 10,000 shares will be filled by first

purchasing 3,000 shares at $24 and buying the remaining 7,000 shares at $24.25

Limit orders, however, are designed to achieve a price at least as favorable as the limit.

For example, if the 10,000 share order had been submitted with a limit of $24.10 rather

than $24.25 as required to purchase the remaining 7,000 shares, then the first 3,000 shares

would be filled but the remaining shares would go unfilled (unless a seller with a sell limit

down to $24.10 or lower stepped into the market)

Traders must understand how the markets in which they trade allow them to present orders:

• Market on open (close)—An order to be executed at the open (or close) of the

market, presumably because these times have good liquidity and will result in a more favorable price outcome

• Market not-held order—Brokers who help fill orders for traders are “not held” to a

particular price or time interval to execute the trade Brokers who feel they may get

a better price later may allow the trader to wait on price

• Participate but do not initiate—Traders do not hold the shares out to other broker/

dealers, but instead prefer to let the other party determine the timing of a trade in exchange for, hopefully, better price execution

• Best efforts order—Traders offer the security only when a favorable trade price

exists, but are usually not allowed to hold the order indefinitely

• Undisclosed (or reserve, hidden, or iceberg) order—Limit order with instructions

to only show some partial amount of the full order Large buy/sell orders will tend

to increase/decrease offer prices Hiding part of the order quantity may prevent counterparties to the trade from holding out for a more favorable price

Traders must also understand special types of trades:

• Principal trade—The broker commits capital to execute a trade quickly, often at a

price favorable to the broker The trade often takes place on time-driven orders that are larger than the market can easily accommodate

• Portfolio trade (or basket trade, program trade)—Execution of a trade involving

a list (basket) of securities, often in an index such as the S&P 500 Index The diversification of the trade often makes it more palatable to the other side of the trade and can be executed at a favorable cost

LOS 31c: Compare alternative market structures and their relative advantages Vol 6, pp 9-17

Types of Markets

Markets are designed to provide price and volume information that is visible to all

participants (transparency), as well as the ability to trade large quantities quickly without dramatically affecting the price (liquidity), and to ensure that trades settle under all market conditions (settlement assurance) Since the 1990s, traders have a much broader range of choices of venues in which to trade securities This market fragmentation has accelerated

with computerized trading platforms that don’t require much, if any, human involvement.Dealer Markets

Dealer markets are those in which an entity (the dealer or market maker) purchases and

sells securities out of its own inventory in order to provide market liquidity Natural

liquidity occurs among a large pool of potential buyers and sellers Dealers can help in

markets that don’t have natural liquidity (e.g., bond markets), where most issues trade less frequently than equities

In a true dealer market, the dealer stands between all buyers and sellers and the market does not provide quoted prices from other buyers or sellers In other dealer markets (e.g., NASDAQ), however, trader quotes are shown along with dealer quotes Dealers purchase

at a bid price and sell at an ask price, with the resulting profit (spread) accruing to the

dealer To complete the nomenclature of transparency, the bid size is the volume associated

with the bid price and the ask size is associated with the ask price Traders wishing to sell

a security benefit from a higher bid price; traders wishing to buy a security benefit from a

lower ask price

Market (or inside) bid describes the highest price a dealer is willing to pay; market (or

inside) ask describes the lowest price at which a dealer is willing to sell Therefore, a

multiple-dealer market may show inside bid and inside ask prices from different dealers

The inside quote includes both the market bid and market ask prices.

The mid-quote for a security is halfway between the market bid and ask prices at any given

time

Although a particular dealer may offer a more favorable quoted price for a security, it may

make sense to specify another dealer, with a better ability to stand behind the quote (if

allowed by the market) For example, counterparties in the currency markets must also be

concerned with the credit quality of the other counterparty

In closed-book markets, not all bid-ask data may be available to all parties and the trader

may have to pay commission to a broker to locate the best price Price improvement results

when a trader steps in front of the best quoted bid or ask (i.e., sellers get a higher bid and

buyers get a lower ask price than quoted)

LOS 31b: Calculate and interpret the effective spread of a market order

and contrast it to the quoted bid-ask spread as a measure of trading cost

Vol 6, pp 10-11

Trading costs can be determined from the quoted bid-ask spread The trader may, however,

receive more favorable prices on either or both the bid and ask sides Therefore, effective

spread may better measure the trading cost:

Effective spread = 2 x Execution price - (Bid price + Ask price)

2

Note that this calculates effective spread for a purchase, and will be mid-quote less

execution price for a sale.

Effective spread better captures actual costs because it considers price improvement

offered by dealers over the quoted spread as well as market impact (i.e., tendency for

large trades to move the market) Average effective spread (i.e., dollar-weighted or share-

weighted) is often used when orders execute across several prices Average effective spread

can often be used to identify liquidity Higher volume securities typically allow narrower

dealer spreads, presumably because the dealer takes less risk of being unable to offload

the position quickly Lower volume securities require wider dealer spreads to compensate

dealers for the risk of being unable to offload the position quickly

Transaction Bid AskShares Price Price Volume Price Volume

Based on this information, which of the following will be lowest?

A Mean effective spread

B Dollar-weighted effective spread

C Share-volume weighted effective spread

Solution:

A First, calculate the effective spreads:

Effective spread = 2 x Execution price - (Bid price + Ask price)

= 2(21.24-21.24) = 0

2(21.30-21.26) = 0.04 and 2(21.16-21.15) = 0.02

Average effective spread is (0 + 0.04 + 0.02)/3 = 0.02

Dollar weights of three trades are based on the total dollar trading volume of $21,240,

$63,900, and $126,960 The dollar weights are 0.100, 0.301, and 0.599 for the three trades, respectively

Dollar-weighted spread is 0.100(0) + 0.301(0.04) + 0.599(0.02) = 0.024 Share-volume weighted spread is 0.10(0) + 0.30(0.04) + 0.60(0.02) = 0.024

Therefore, mean effective spread is lowest

Order-Driven Markets

Transactions prices in order-driven markets are established by public limit orders to buy

or sell No dealer stands between buyers and sellers, although either buyer or seller may

be represented by a broker Dealers may trade with other traders in order-driven markets Traders do not choose the other side of the trade (as in dealer-driven markets) because orders execute with the first applicable quote in the market In some cases, trades may be executed at more favorable prices because traders do not need to go through a dealer who gets a cut Alternatively, trades may be executed at less favorable prices because no dealer exists to provide liquidity when liquidity is limited

®

For equity trades, order-driven markets have become more popular.

Types of order-driven markets include:

• Electronic crossing networks—Crossing networks serve primarily institutional

investors by batching orders and matching them (crossing them) at various times

during the day, at prices derived from other markets in volume based on the

smallest quantity submitted Traders are not assured of a match because there is no

dealer standing ready to buy or sell The orders are anonymous to the market, so

information about the buyers and sellers is not leaked Although orders submitted

indicate the demand (buy) or supply (sell) quantities of a security, there is no price

discovery because orders trade at the prevailing price for that batch of orders That

is, more buyers cannot be brought into the market by higher prices Therefore,

traders who do not purchase or sell as much as they desire may trade the remainder

on other markets or leave the remaining order on the ECN for the next batch to

process Unmatched orders are not announced

• Auction markets—Periodic/batch auction markets have periodic price setting and

continuous auction markets have ongoing price setting Some stock exchanges

open and close by batching orders at the prevailing market price, and the Tokyo

stock market operates this way after the mid-day lunch break Auction markets

allow price discovery and avoid the problem of partial fills by finding a price at

which sell orders can be filled

• Electronic limit-order markets (automated auctions, ECNs)—Similar to electronic

crossing networks because they are anonymous and computer-based, these markets

instead provide continuous execution and allow price discovery NYSE area

exchange and Paris Bourse are examples These may also be referred to as electronic

communications networks, and the acronym ECN is reserved for these rather than

for electronic crossing networks Hedge funds or day traders may make a profit by

providing liquidity in such markets, thus helping to create tighter spreads

Brokered Markets

In the U.S., broker markets traditionally referred to a less formal communications process

away from the exchange floor, and now describe a process whereby a broker skillfully

introduces a trade to dealers or to the market This process primarily exists now in lower-

liquidity situations such as block orders and on smaller public exchanges Block orders

have been defined here as large trades relative to liquidity size

Brokers may risk their own capital on all or a portion of the security (i.e., position the

trade), use their reputation to instill confidence in the other side of the trade, or simply

weed out potentially unsuitable traders who would be likely to front-run the initiator (i.e.,

exploiting information about the initiator’s reasons for buying or selling to execute their

own trades at more favorable prices)

Hybrid Markets

Hybrid markets combine features of separately described markets The New York Stock

Exchange (NYSE), for example, batches orders presented after the close and before the

next open (batch auction market) It then trades continuously during the day (continuous

auction markets) Specialists then help provide liquidity similar to the role of dealers in

quote-driven markets

Example 1-2

Which of the following market types would be least likely to attract large institutional

traders more interested in price than in immediacy of the trade?

A Continuous auction market

B Electronic crossing network

C Electronic limit-order market

Solution:

A While auction markets can aid in price discovery at which a large order can be successfully executed, this may require discounts to a desired price Auction markets also may react negatively to a large sell order, believing that the sale contains information This can cause liquidity to diminish and require an additional discount

The Roles of Brokers and Dealers

LOS 31d: Compare the roles of brokers and dealers Vol 6, pp 18-19

Portfolio managers and traders should have a deep understanding of the roles undertaken

by dealers and brokers In some cases, sell-side firms (i.e., investment banks and retail brokerage) act as both a broker and a dealer, taking a commission from trading clients while acting as a dealer in the security While a trader gains by narrower bid-ask spread,

a dealer gains by wider bid-ask spreads Brokers, on the other hand, tend to have a less adversarial relationship with dealers

For the investor or trader, brokers:

• Present orders to the market;

• Find buyers/sellers, sometimes requiring the broker to act as a dealer;

• Use discretion (sometimes for their own gain);

• Supply market information such as demand/supply, counterparty identities, and risks of trading; and

• Provide support services (e.g., recordkeeping, cash management, arranging financing for leverage, etc.)

Dealers and other sell-side traders want to know a trader’s motivation and are reluctant to deal blindly with another party (i.e., due to asymmetric information problems) Otherwise,

participants may suffer the adverse selection accompanying a trader’s desire to sell (buy)

at an uninformed dealer’s bid (ask) price Brokers may be useful in mediating dealer/trader concerns about the transaction

LOS 31e: Explain the criteria of market quality and evaluate the quality of

a market when given a description of its characteristics Vol 6, pp 19-21

Market Quality

Markets may be judged by their liquidity, transparency, and order completion

Liquidity

Liquid markets are characterized by:

• Resilience—Changes in perceived value tend to be small and quickly reflected in

price;

• Quote depth—A reasonable quantity of securities at each quoted bid and ask price;

and

• Narrow bid-ask spreads—Tight quoted and effective spreads indicate low

transactions costs to traders

Liquid markets allow trading on specific insights without significant price impact

Liquidity adds value to companies wishing to list shares on an exchange because the

exchange allows investors to assume a position with little risk that they will be unable to

sell the shares Liquid investments enable companies to attract maximum amount of capital

from an initial or subsequent offering because companies can avoid selling their stocks

with an illiquidity discount if their stocks are highly liquid

Market liquidity develops as the result of:

• Many participants (both buying and selling);

• Diversity (investment needs, opinions, and information);

• Convenience (well thought out trading software or accessible physical location);

and

• Integrity (investigation of complaints, auditing financial condition, and trader

compliance, etc.)

Transparency

Market transparency can be divided into:

• Pre-trade transparency—Traders easily gain accurate information about prices and

trade volume; and

• Post-trade transparency—Fast and accurate trade reporting.

Assured Completion

Assured order completion implies that clearing firms or individual brokers guarantee

completion of the trade, and trading counterparties are held to their obligations

Example 1-3

A decline in market quality could best be illustrated by:

A tighter quoted spreads

B tighter effective spreads

C decreasing quoted depth

Solution:

C Decreasing quoted depth implies a decline in market quality because buyers and sellers wishing large volume at a particular price must break up their orders (i.e., less liquidity)

LESSON 2: THE COSTS OF TRADING

LOS 31f: Explain the components of execution costs, including explicit and implicit costs, and evaluate a trade in terms of these costs Vol 6, pp 21-29

Traders often compare execution markets and strategies with an eye toward minimizing costs along with the relative immediacy of their need to trade Trading costs today are viewed as negative performance, so managers and traders must assess implementation costs versus the information advantage they possess for security value relative to price

Transaction Cost Components

Explicit trading costs arise from broker commissions, exchange fees, duties and taxes, etc Implicit trading costs, however, could not be explicitly shown on a trade ticket but must be

derived from information about a trade:

• Bid-ask spread;

• Market impact (price impact)—Price movement resulting from the need to attract

additional demand or supply;

• Unrealized profit/loss (missed trade opportunity cost)—Arising from failure to

execute a desired trade in a timely manner, often as a result of attempting to get a better price; and

• Slippage (delay costs)—Arising from lack of liquidity (e.g., quoted depth) at a

particular price

In addition to opening and closing prices, or the midpoint quote, traders also use volume-

weighted average price (VWAP) as a reference to determine if they traded at a good

price VWAP is the price for each share transacted multiplied by that NO transaction’s percentage of total volume for the period, usually daily A number of vendors (e.g., Bloomberg) supply this data for transacted securities so that each firm does not need to independently calculate this measure

VWAP offers little information on trades that represent a large portion of periodic volume, however, because such a trade heavily influences the weighted-average In the extreme,

a single trading desk that purchases all the shares during the day would have an average

price equal to VWAP

A trader can also game the VWAP measure by, for example, waiting until the end of the

day to determine whether trading at a particular price will be better than VWAP (which

approaches its daily value toward the end of the trading day) If the end-of-day price is not

better than VWAP, the trader can wait until the next day to enter the trade at the opening

price Using VWAP calculated over multiple days can help reduce this incentive, but

results in less precision for estimated trading costs Multiple-day VWAP may be useful,

however, for measuring effectiveness of trading illiquid assets

Example 2-1

Attempting to game effective spread as a transactions cost measure by waiting for the

market to approach a limit price will most likely result in:

A delay costs

B showing losses on the sell side

C increases in estimated transactions costs

Solution:

C Although trading in this manner will result in negative estimated transactions

costs, there will be increased likelihood of positive opportunity costs and delay

costs

LOS 31g: Calculate and discuss implementation shortfall as a measure of

transaction costs Vol 6, pp 24-27

The most exact approach to transactions cost measurement involves establishing a

hypothetical portfolio with security prices determined at the trading decision (i.e., decision

price, strike price, or arrival price), and measuring the difference with the actual portfolio

Implementation shortfall captures implicit costs, which may be high for large executions,

as well as the explicit costs of trading Implementation shortfall fo r purchases is calculated

as the hypothetical portfolio return less the actual portfolio return; implementation

shortfall fo r sales is calculated as the difference between the actual portfolio return and the

hypothetical portfolio return

Thus, positive implementation shortfall/or purchases indicates that the actual purchase

cost more than the hypothetical purchase; positive implementation shortfall fo r sales

indicates the actual sale generated less than the hypothetical sale In both cases, this results

from the friction of transactions costs

In order to understand each component of implementation shortfall, first consider that there

will be a desired (hypothetical) number of shares S h purchased or sold at the portfolio

manger’s decision (hypothetical) price P h - Note that the decision price could be stated as a

mid-quote price, rather than the bid (for sales) or the ask (for purchases)

The actual number of shares purchased/sold S will be transacted at the execution price PE

If the order to purchase/sell shares is carried over from one day to the next, however, the closing price from the previous day (rather than the desired/ hypothetical price) will then

become the relevant price PR for determining realized profit and slippage costs Unrealized profit/loss on the actual portfolio will depend on the last available valuation price PL The components of implementation shortfall costs fo r purchases can then be calculated as

a percentage against the hypothetical portfolio value (SH x PH) as follows:

• Explicit costs—Commissions, taxes, and fees.

Expicit costs = Commissions, taxes, and fees

SH *P«

• Realized profit/loss—Price movement from the decision price (i.e., the relevant

price, often the previous close) to execution price for the portion of the order executed:

• Unrealized profit/loss (missed trade opportunity cost)—Trade cancellation price

less the original benchmark (hypothetical) price for the unfilled portions of the original order

UPL = (SH - S ) x ( P L - P H)

X ^H

Implementation shortfall itself will be the sum of the various components, or can be

simplified and represented fo r purchases as:

Implementation shortfall = Commissions + S(PE - PL) + SH(PL - P H)

X ^H

For sales, the prices used in the numerator for all the above computations will be reversed.

Example 2-2

XYZ Corporation shares close Monday at $31.00 Before trading on Tuesday, a portfolio

manager sends a day order to her trading desk to purchase 1,000 shares of XYZ at

$29.98 or better per share The order expires unfilled at the end of the day with a closing

price of $30.00 Before trading on Wednesday, the PM sends a new day order to her

trading desk to purchase 1,000 shares of XYZ at $30.01 or better The trader is able to

fill 750 shares at $30.01 with a commission of $112.50 The price of XYZ shares closes

at $30.15 on Wednesday The PM decides not to submit another order for the remaining

250 shares

The implementation shortfall components are:

• Commission and fees of 36 bp (112.50/31,000)

• Realized profit/loss (late trade opportunity cost):

RPL = _ S x ( P E - P R)

X ^H

750 x ($30.01-$30.00) 1,000 x $31.00 = 0.00024 or 2 bp

Slippage costs (delay) from the desired price if execution were to occur at the

relevant price:

Delay -_ S x ( P R - P H)

$H X ^H

750 x ($30.00-$31.00) 1,000 x $31.00 = -0.02419 o r -2 4 2 bpUnrealized profit/loss (missed trade opportunity cost):

$H X ^H

(1,000 - 750) x ($30.15 - $31.00)

1,000 x $31.00 -0.00685 or - 69 bp

Implementation costs for this purchase are the total of these items, or -273 bp

This can also be found using the formula for implementation costs, and provides

Note that the negative sign indicates a negative shortfall (a favorable result because the shares were executed at a favorable price), although pre-trade cost estimates will always be positive owing to the commissions and fees and the assumption of trading at a relevant price.

Some firms complement implementation shortfall by accounting for the anticipated trading costs as if the trades were executed in an expected market and component costs are at expected levels

The application of benchmark price based on trading cost measures (i.e., VWAP, effective spread, and implementation shortfall) cannot be effective if a market lacks accurate price and volume information Further, the implementation shortfall approach cannot be effective if the asset trades infrequently because the relevant price will reflect only a trade that happened much earlier

Exhibit 2-1: Comparison of VWAP and Implementation Shortfall

• Can assist traders during execution

• Best for smaller trades in non-trending markets

• Does not account for costs of delayed or cancelled trades

• Misleading for trades that are high percentage of volume

• Trade size/market impact do not factor in

• Delaying trades can improve trade price, but may increase opportunity cost

• Recognizes price immediacy

• Allows cost attribution

• Works in optimization programs by reducing turnover

• Cannot be gamed

• Requires extensive data collection/ interpretation

• Unfamiliar framework for traders to use

LOS 31h: Contrast volume weighted average price (VWAP) and implementation shortfall as measures of transaction costs Vol 6, pg 28 LOS 31i: Explain the use of econometric methods in pretrade analysis to estimate implicit transaction costs Vol 6, pp 30-31 * •

Pretrade Analysis: Econometric Models for Costs

Econometric models that help produce reliable pre-trade cost estimates are typically related to:

• Risk—Volatility of security returns;

• Liquidity—Price level, volume, market cap, trading frequency, bid-ask spread, and

index membership;

• Trade size as a percentage o f average daily volume;

• Momentum—More costly to purchase in an up market than a down market; and

• Trading style—Market orders (aggressive) cost more than limit orders (passive).

The cost function estimated with the model using these variables can be used to estimate:

• Optimal trade size; and

• Trading costs to use in assessing quality of actual trade execution

Example 2-3

Elvin Bishop has identified an econometric trading cost model that estimates Market

A has trading costs, excluding transactions charges, 20 bp greater on average than in

Market B Transactions charges, however, tend to run 20 bp greater on average in Market

B than in Market A Which of the following is the best description of how Bishop should

conduct his trades in a thinly traded security where time is not of the essence?

A Transact in Market A only

B Transact in Market B only

C Transact in either Market A or Market B, depending on quote depth

Solution:

A Because the trading costs (usually associated with lack of liquidity, etc.) in

Market A are higher, but Market B has higher transactions costs (i.e., broker

commissions, fees, etc.), Bishop should transact in Market B when he can go

direct to a dealer and Market A when he requires a broker, as in the case of a

thinly traded security

LESSON 3: TYPES OF TRADERS AND THEIR PREFERRED ORDER TYPES

LOS 3Ij: Discuss the major types of traders, based on their motivation

to trade, time versus price preferences, and preferred order types.

Vol 6, pp 33-36

Investment management style directly affects implementation strategy and, therefore,

cost Strategies that take a more active management approach (i.e., based on momentum,

news, frequent rebalancing, etc.) tend to have higher transactions and trading expenses A

successful strategy depends on information content of the trades earning returns greater

than costs

Therefore, trade urgency (i.e., necessity for quick and certain execution) becomes the

fundamental determinant of trading strategy Urgent trades must be executed quickly to

take a position before the market becomes aware of news about the company Non-urgent

trades may instead use limit orders to attain a particular price

Trader Motivations

A trader’s motivation suggests trader classifications:

• Information motivated—New information can move prices, and traders depend on

quick execution to capture profits from under- or over-valued securities before the rest of the market assimilates the information These are usually a single security, transacted in large blocks These traders avoid publicity and notoriety so that other traders won’t avoid taking the other side of the trade

• Value motivated—Research and valuation suggest theoretical price targets These

traders purchase securities when actual prices fall below the theoretical prices (value) These traders may make infrequent trades over a longer time horizon in order to avoid price movements away from their intention

• Liquidity motivated—Traders may need liquidity to fund other positions with more

profit potential, adjust portfolio exposures to certain assets, or simply to buy a new boat These traders often provide liquidity for other types of traders and should not relinquish their positions in such securities too quickly

• Passive—Index and other passive strategies attempt to implement strategies with

lower costs, therefore are less sensitive to the timing of trades Indexes themselves

do not consider transactions costs, so to be effective against an index, the trader must find other cost advantages

Other types of traders may span more than one strategy Dealers, for example, require quick executions to earn money off the spread, and will tend to trade more like information-motivated traders in that regard However, they are willing to let the other party determine the timing of the trade in exchange for getting their price, much like passive traders

Arbitrageurs, on the other hand, exploit small price discrepancies in the same asset across

different markets Thus, they are dependent on quick executions at favorable prices

Day traders typically seek to hold positions in momentum securities for a very short

period, but often accommodate other traders much like dealers

Exhibit 3-1: Trader Type by Motivation and Preferences Trader Type Motivation Preference Holding Period

Information Unassimilated information Time Minutes/hours

Liquidity Divest securities, invest

cash, buy things

Time Minutes/hours

Dealers/Day traders Accommodate other traders Indifferent Minutes/hoursTraders in alternative assets tend to follow similar patterns (with the exception of not having a counterpart to day traders) However, alternative assets tend to be less liquid and may require greater holding periods

Traders’ Selection of Order Types

Buy-side traders use various types of orders depending on market conditions and portfolio

manager preferences

Information-Motivated Traders

These traders typically seek the rapid execution and price certainty available through a

dealer, and may act as principals in many cases Dealers often require price concessions,

however, to move the large amount of inventory often required for such trades These

traders may use market orders to disguise the knowledge, supposedly novel, on which they

are trading

Value-Motivated Traders

Because value-motivated traders have independently assessed value, they can use a limit

order slightly above the current price but below their fair value estimate As the market

starts to recognize the undervalued security and bid up its price, the limit order is triggered

The trader can then put in a sell order close to the fair value estimate These traders can

control price, but not timing of the execution

Liquidity-Motivated Traders

These traders typically desire low price impact and low commissions, and can often be

more patient than information-motivated traders as to timing of executions Such traders

may be willing to expose themselves as requiring liquidity, so dealers may be allowed to

offer fewer protections about how the trades are handled

Passive Traders

These traders typically use limit orders, portfolio trades, and crossing networks to reduce

trading costs, and may be able to completely eliminate bid-ask spread costs In exchange,

they accept uncertainty with respect to execution within a reasonable time These strategies

are best suited to moderate-sized trades in markets with broad (rather than concentrated)

participation

LESSON 4: TRADE EXECUTION DECISIONS AND TACTICS AND SERVING

THE CLIENT’S INTERESTS

This section examines the combinations of security characteristics, market types, and order

types useful in implementing various strategies

Handling Trades

A good trader creates a daily strategy that minimizes costs in the context of market

conditions and the portfolio manager’s trading needs Traders must also consider cash

balances, client trading restrictions, and broker allocation commitments Additional

considerations by trade type include: •

• Small, liquidity-motivated trades—Suitable for direct market access (DMA) that

permits buy-side traders to place trades directly to the market via the brokers’

platform Also suitable for algorithmic trades in which preprogrammed trading

instructions are delivered to the brokers’ platform The main point here is not to involve senior traders and brokers in trades where they cannot add value.

• Large, information-motivated trades—Senior traders and skilled brokers can

make a difference here by providing the market with only the information content necessary to give the market incentives to trade larger transactions while balancing impact and delay costs

The process starts by determining the size of the specific order to trade and the urgency of that trade The tactical concerns then revolve around:

• Trading tactics, such as how to reveal only the information necessary to complete the trade;

• Which specific securities within the position to trade (e.g., to optimize tax consequences);

• Using DMA/algorithmic trades or the special handling a trader/broker can bring;

• Lowest overall cost platform;

• Alternative plan if the low cost plan fails;

• Determining which broker to use, if one is needed; and

• Feedback to provide to the portfolio manager

Objectives in Trading and Trading Tactics

LOS 31k: Describe the suitable uses of major trading tactics, evaluate their relative costs, advantages and weaknesses, and recommend a trading tactic when given a description of the investor’s motivation to trade, the size of the trade, and key market characteristics Vol 6, pp 37^40 •

In developing and implementing trading tactics, traders often make errors related to:

• Giving up profit during execution of a value-motivated transaction (i.e., selling time too cheaply);

• Giving up profit during execution of an information-motivated transaction (i.e., buying time too expensively); and

• Releasing information that allows other traders to exploit or avoid the position The latter is often the most costly mistake

Liquidity at Any CostThese traders are often able to attract brokers interested in the information content of their trades, but usually only get the liquidity they need by giving price concessions or at high commission rates Liquidity traders often create a market disturbance when they enter the market as their institutional size trades challenge the existing liquidity in the market Normally non-aggressive traders (e.g., mutual funds) may be pushed into this position if they receive excessive end-of-day liquidation requests

Costs-Are-Not-Important Focus

Market orders exemplify this focus, dominated by mixed investment strategies in which

information, value, or liquidity focus is difficult to assign This focus works best for small

trade sizes and actively traded issues Traders do not actively need to execute these orders

because exchanges set up procedures to ensure fair execution, with the executed price

often very close to expected fair value Market orders are easy to execute and are often

used to generate soft dollars for the brokerage

Traders may use buy-limit orders that improves on the best bid or sell-limit orders that

improve on the best ask price In most other cases, however, traders hand off discretion to

the market

Need-Trustworthy-Agent Focus

Traders in thinly traded issues may choose to execute orders through a floor trader

who can uncover interest or take advantage of it as it arrives in the market The trader’s

order may be packaged with other orders, or may be split up and executed as special

orders Such trades often reveal important information to the floor broker, and may even

encourage them to participate in trades This makes it difficult for the trader to know if the

information was used in his/her best interests

Advertise-to-Draw-Liquidity Focus

Advertising publicly displays trading interest in advance of the actual order, as in the case

of IPOs, secondary offerings, and sunshine trades, which advertise the price to keep it

more stable based on the volume involved This has the disadvantage of alerting traders to

a possible front-running opportunity by trading in front of the actual trade to establish the

contra-position

Low-Cost-Whatever-the-Liquidity Focus

These trades attempt to earn extra profit by using a limit sell order above the inside ask

price or a limit buy order below the inside bid price Because of the potential wait for

the order to fill, these are best suited to passive or value strategies Minimizing trading

costs also drives these trades Disadvantages of waiting include the possibility of new

information entering the market and creating less profit potential Buy limits under the

market price run the risk of being hit when unfavorable news hits the market At that point,

prices may fall even further

Considerations associated with these trading strategies are shown in Exhibit 4-1

Exhibit 4-1: Trading Objectives

Liquidity at Immediately Upsetting Guaranteed Informationany cost execute large

blocks

supply/demand execution leakage and

market impact possibleNeed

trustworthyagent

Low level advertising on large trades;

possible hazardous situation

Highercommissions;

informationleakage

Priceimprovement due to ability

to wait

Lose trade control

Costs are not important

Certainexecution

Spread; potential price impact

determinedprice

Market-Lose trade control

Advertise to Large trades High Market- Possible frontdraw liquidity without

informationadvantage

(organizational and operational) cost

determinedprice

“chasing” the market with limit orders

automated trading (i.e., non-manual trading) such as:

• Algorithmic trading—Based on quantitative mles and subject to user defined constraints and benchmarks (e.g., portfolio trades for an entire basket of

securities); and

• Smart routing—Automatically routing trades to the venue with lowest cost

execution

Algorithmic trading executes orders with controlled risks and costs by breaking larger

orders up to match market flow Traders should be cautious that an algorithmic system that executes the easiest trades first also considers more difficult trades or the trader could be stranded at the end of the trading day

“Algo” trading may be as simple as rules-based pairs trading, in which a long position

in one stock and a short position in another stock will be simultaneously bought or sold

depending upon certain conditions (e.g., price ratio crosses a particular threshold) This

early strategy has developed into trading that considers horizon, style, and venue rules:

• Logical participation strategies

o Simple logical participation strategies—Participate in market flow without

undue visibility and price disruption:

■ Volume-weighted average price (VWAP) strategy—Match the

expected (forecast) volume for the stock

■ Time-weighted average price (TWAP) strategy—Breaks order up

for exposure at various time periods during the day, useful when the volume is light or erratic

■ Percentage o f volume strategy—Trading occurs as some percentage

of overall market volume until completed

o Implementation shortfall—Also known as the arrival price strategy,

this approach seeks to minimize the weighted-average of impact and opportunity costs by “front-loading” executions into the early part of the trading day These strategies are especially useful when there is a need for formal control to assure executions such as in the case of portfolio trades or multi-period trading when a portfolio manager hands off to a new manager

• Opportunistic strategies—These strategies typically involve passive holding

and opportunistically seizing liquidity In pegging and discretion strategies,

for example, traders may incur negative costs by buying at the bid price or, if

the spread is narrow, at the ask price This may involve crossing internally or

externally using hidden orders

• Specialized strategies—Smart routing can be thought of as a type of specialized

strategy Other strategies involve passive orders which do not guarantee execution,

“hunter” strategies that attack liquidity when offered, and benchmark-based

algorithms (e.g., market on close that purchases a basket at the closing price)

The Reasoning Behind Logical Participation Algorithmic Strategies

LOS 31m: Discuss the factors that typically determine the selection of a

specific algorithmic trading strategy, including order size, average daily

trading volume, bid-ask spread, and the urgency of the order Vol 6, pp 45^47

Many studies have concluded that increasing order size tends to increase market impact

costs Simple logical participation strategies assume that traders minimize market impact

costs when they trade in proportion to market volume This follows the logic that trades

have a price-time tradeoff and breaking large orders into smaller orders will improve price

at the expense of time

Simple logical participation strategies such as volume weighted average price (VWAP)

will be more appropriate when trades have low urgency, low bid-ask spreads, and represent

a small percentage of trading volume in the security

A question regarding appropriate trading strategy given bid- ask spread, order size, average daily trading volume for the investment, and urgency would make an excellent multiple choice question.

The more sophisticated implementation shortfall strategies recognize that market impact

costs must also be balanced against missed trade opportunity costs, which increase with

the time between order entry and execution This recognition suggests that implementation

shortfall strategies trade a high proportion of volume early in trading rather than later, and

©

the weighted average of higher market impact costs will be offset by the weighted average

of lower missed trade opportunity costs

Implementation shortfall strategies will be more appropriate when greater trade urgency requires a balance between market impact costs and missed trade opportunity costs (e.g., information trading, acquisition, etc.)

Traders will be most likely to forego algorithmic trading for a broker or crossing system when there is low urgency but high bid-ask spreads

Example 4-1

A trader sees the following pending trades on his blotter:

Symbol Side Shares Avg Vol Price % Spread Urgency

A Buy 25,000 50,000 14.25 0.45 Low

B Buy 215,000 4,250,000 48.17 0.04 Low

C Sell 50,000 500,000 24.50 0.04 High

Which of the following shares (represented by their symbols) would most likely be

traded using a broker?

Trade Management Guidelines (CFA Institute)LOS 31n: Explain the meaning and criteria of best execution Vol 6, pp 47^48

CFA Institute’s Trade Management Guidelines (“the Guidelines”) were designed to

provide investment managers with an ethical approach to best execution for clients Best execution concerns the methods used to make trades in a way that minimizes frictional trading costs within the constraints (e.g., urgency) necessary for the trade

The Guidelines identify the following characteristics of best execution:

• Value of trading decisions and portfolio strategy cannot be separated (e.g.,

urgency/information decisions necessitate a different cost outcome than value

decisions);

• Trading costs cannot be determined ex ante because best execution occurs through

negotiation between buyers and sellers;

• Ex post measurement of best execution may be possible over a sequence of trades,

but seldom on an individual-trade basis; and

• Trading is a process with standards that address behaviors rather than outcomes

LOS 31o: Evaluate a firm’s investment and trading procedures, including

processes, disclosures, and record keeping, with respect to best execution

Vol 6, pp 48-49

The Guidelines recommend practices rather than specific methods for measuring

transactions costs Thus, the Guidelines have been segmented into:

1 Processes—Firms should formalize policies and procedures to achieve best

execution for clients These policies and procedures should address managing trade

decisions and measuring the quality of outcomes

2 Disclosures—Firms should disclose information about agents, trading techniques,

and venue selection, as well as any trade-related conflicts of interest

3 Recordkeeping—Firms should maintain records supporting client disclosures and

compliance with the firm’s policies and procedures

The Guidelines focus firm efforts on best execution which, in the end, results from serving

client needs for trading expertise

Importance of Ethical Focus

LOS 31p: Discuss the role of ethics in trading Vol 6, pg 49

Trading has come to rely less on using middlemen Brokerage commissions have

diminished as a source of income, implicit costs have increased as a percentage of total

trade costs This has made it difficult to align buy-side client/trader interests with sell-

side broker/dealer interests As a result, trading has become adversarial and each party’s

information is seen as a potential threat Traders must rely on other traders’ reputations

and their willingness to build and maintain long-term relationships, especially where it

concerns each trader’s willingness to stand behind their promises

Traders who fail to act ethically will soon find no tmst among their peers

Both the portfolio manager and buy-side trader must focus on client interests and act in

a fiduciary capacity The trader’s loyalty to his firm and other traders must be carefully

balanced against the fiduciary duty to the client

Rea d in g 32: Mo n it o r in g a n d Re b a l a n c in g

Time to complete: 1 to 2 hours

Reading summary: You should be able to discuss monitoring investor portfolios for

material changes in investor circumstances, divergence from economic expectations

and relationships, and changes in portfolio allocation relative to the SAA Be able to

recommend and justify changes to an IPS/S AA when investor circumstances change You

should also be able to compare and contrast various strategies for rebalancing portfolios

when they diverge from the SAA

INTRODUCTION

After a well-defined investment policy statement (IPS) is developed, a portfolio manager

must keep his fiduciary duty by regularly monitoring the client’s portfolio To ensure the

client’s objectives are met and constraints are addressed, a portfolio manager often needs

to rebalance the client’s portfolio Rebalancing the portfolio is particularly important in

response to changes in the client’s circumstances, volatilities in market, and fluctuations in

asset values

This lesson will provide you with the tools to:

1 Discuss fiduciary duties related to monitoring an investor’s portfolio and the

cross-feedback between a portfolio and the investor related to changes in investor

circumstances, economic/market conditions, and individual holdings in the

portfolio;

2 Recommend and justify portfolio revisions given benefits and costs of various

rebalancing methods; and

3 Develop appropriate rebalancing strategies given the investor’s return expectations

and risk tolerance

LESSON 1: MONITORING FOR IPS CHANGES (INDIVIDUAL AND

INSTITUTIONAL)

LOS 32a: Discuss a fiduciary’s responsibilities in monitoring an investment

portfolio Vol 6, pp 66-82 * •

Monitoring involves systematically tracking information to achieve investment goals

Investment managers should monitor all aspects of their client portfolios, including:

• Investor circumstances and constraints;

• Changes in markets and the economy; and

• Portfolio results

Monitoring Changes in Investor Circumstances and Constraints

Advisors should pay attention to client needs and circumstances in all interactions, but

special opportunities to assess client circumstances arise at periodic review meetings

Private wealth managers will typically meet with clients semi-annually or quarterly while

institutional managers will tend to meet with clients annually for an asset allocation review

Investor Circumstances

LOS 32b: Discuss the monitoring of investor circumstances, market/

economic conditions, and portfolio holdings and explain the effects that changes in each of these areas can have on the investor’s portfolio.

Vol 6, pp 67-83

For private wealth clients, life events like changes in marital status, employment, health, birth of a child, or death of a parent may affect expected family income, expenditures, retirement plans, and risk tolerance These changes often call for a review of an investment policy statement and the overall financial strategy For institutional clients, changes in governance practices, mandates from trustees, requirements for beneficiaries, and operating expenses all could potentially contribute to the need for portfolio changes Frequent communications should be established with clients to ensure awareness of changes

Investor return requirements may change as financial goals move toward achievement or disaster, as measured by the investor’s wealth Increases in wealth typically allow investors to pursue greater returns because they can accept greater risk Investment managers, however, should counsel clients not to change their expectations based on short-term market results.Liquidity Needs

A liquidity requirement involves anticipated or unanticipated needs for cash in excess of new contributions For private wealth investors, change in liquidity needs might be the result of divorce, retirement, loss of employment, lawsuit settlement, and purchase of a home For institutional clients, events such as a withdrawal of benefits from defined-pension plans and need for capital projects might require additional liquidity Investment managers should try to meet changing liquidity needs for private or institutional clients, although such needs may constrain the investments selected away from less liquid investments

Time HorizonTime horizons are different for individuals and institutions While individual investors

go through a typical 60-year investment life cycle, institutions are often assumed to exist

in perpetuity Portfolio managers typically reduce investment risk as an individual ages

by allocating assets to safer instmments such as bonds The multi-stage time horizon for individuals as they move through their life cycles will often require managers to make more than one adjustment to the strategic allocation An unexpected death of the breadwinner, for example, will require immediate attention

Institutional investors, on the other hand, typically work with clients who have unlimited time horizons and for whom appropriate asset allocation will hardly change Investment policy may require abrupt changes, however, when the last income beneficiary dies and the remaining funds (residue) pass to those with claims on the remaining funds

(remaindermen) Sudden employment changes at a company may necessitate asset

allocation and other changes to a pension fund

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