Archive for March, 2008

Forming an Investment Return Objective

Investment return objectives should be consistent with established risk objectives. How the return objective will be measured (typically total return) is important. Will it be on a pre-tax or after-tax basis? In real (inflation-adjusted) or nominal terms?

Return objectives depend both on how much is desired and how much is required in order to meet investor objectives. Once these levels are established, a specific risk objective (i.e. “average annual after-tax returns of at least five percent”) can be established.

Posted on 31st March 2008
Under: Active Management, Asset Allocation, Portfolio Management | No Comments »

Evaluating Investment Manager Performance

Performance evaluation is a necessary step in the portfolio management process. It allows the investor to monitor the progress being made toward goals and also to assess the skill of managers being used.

A skill assessment has three components: performance measurement, performance attribution and performance appraisal.

Performance measurement is simply determining the rate of return earned on investments. Performance attribution determines the sources of that return, which could include the strategic asset allocation, market timing, and security selection. The performance appraisal compares the manager’s return to that of the agreed-upon benchmark.

Posted on 30th March 2008
Under: Active Management, Asset Allocation, Portfolio Management | No Comments »

Identifying Nonfinancial Risk Exposures

Portfolios and firms face a number of non-financial risks that must be identified, measured and monitored. These include:

  • Operational risk – the loss caused by failures in systems and procedures, or from external events
  • Model risk – incorrect or misspecified valuation models
  • Settlement (Herstatt) risk – occurs when one counterparty to a transaction is settling the account, while the other party is declaring bankruptcy
  • Regulatory risks – uncertainty regarding how transactions will be regulated or how regulations may change
  • Legal/contract risk – the potential loss when a contract is not upheld
  • Tax risk – uncertainty surrounding tax laws
  • Accounting risk – uncertainty regarding proper way to record transactions or regarding potential rule changes
  • Sovereign and political risks – regime changes that could affect business relationships, or the potential default of a sovereign borrower

Posted on 29th March 2008
Under: Governance, Portfolio Management, Risk Management | No Comments »

Types of Hedge Funds

Hedge funds come in many flavors, including:

  • Equity market neutral funds, which offset long positions in stocks with equal short positions in order to eliminate systematic market exposure (beta).
  • Convertible arbitrage funds attempt to exploit anomalies between the price of a stock and the prices of instruments convertible into the stock.
  • Fixed income arbitrage tries to predict changes in credit ratings or the term structure of interest rates. Typically these funds strive for market-neutral positions by offsetting long and short positions.
  • Distressed securities funds exploit the fact that many investors lack the desire to participate in the bankruptcy process or the ability to identify their value.
  • Merger arbitrage captures any spread between the price of a company and the price that a planned acquiror has offered.
  • Hedged equity funds hold both long and short positions but typically remain net long.
  • Global macro funds exploit systematic market moves in currencies, futures and option contracts.
  • Emerging markets funds focus on less mature investment markets.
  • Funds of funds invest in a number of other hedge funds, offering diversification at the cost of double fees.

Hedge fund styles, more generally, include:

  • Relative value, which seeks to exploit valuation discrepancies between their long and short positions
  • Event-driven, which focus on opportunities created by corporate actions such as mergers or offerings
  • Equity hedge, which invest long and short for varying degrees of market exposure and leverage
  • Global asset allocation, which opportunistically go long or short a variety of assets
  • Short selling, which shorts equities in anticipation of a market decline

Posted on 28th March 2008
Under: Active Management, Alternative Assets, Asset Allocation, Hedge Funds, Portfolio Management | No Comments »

Direct Investments in Real Estate

Direct investments in real estate offer a number of advantages and disadvantages relative to other asset classes.


  • Tax subsidies for certain expenses (depreciation, mortgage interest)
  • Access to low-cost financing via mortgages (improved leverage)
  • The ability to take action related to property management confers a control premium
  • Owning multiple properties can confer geographic diversification
  • Compared to equities, real estate returns are less volatile


  • Properties often cannot be divided, so each can represent a large position within the portfolio
  • Uniqueness of properties results in high costs for gathering information
  • Brokerage commissions are high
  • Operating and maintenance costs are high, and special expertise is often needed
  • Potential risks such as neighborhood deterioration can be outside the owner’s control
  • Tax advantages are subject to political risk

Posted on 27th March 2008
Under: Active Management, Alternative Assets, Investing in Real Estate, Investment Returns, Portfolio Management | No Comments »

Sponsored Post: Credit Card Comparison Site

As anyone with a mailbox well knows, hardly a day goes by without receiving one or more offers for new credit cards. The problem is not so much getting credit, but choosing the card that best meets an individual’s needs. With this in mind, Apex Credit Cards has built a site around credit card comparisons.

The site has summarized offers for more than 170 credit cards. Users can click on a category, such as “Low APR,” to compare a dozen or more offers from different issuers. Included in the summary are details of the permanent APR, any introductory APR and the term of the introductory APR, annual fees, setup fees and the credit rating one needs in order to be approved for the card. When you find a card that fits your needs, you can click on an “apply” button to go directly to that card’s application.

Other categories include:

  • Top rated
  • Bad credit
  • Business
  • Canadian
  • Prepaid debit
  • Reward cards (which has 15 sub-categories)
  • Spanish
  • Student
  • Teenagers

All in all, the site allows comparison of MasterCard, Visa, Discover and American Express offers from no less than 23 issuers. There is also a way for current holders to review each card offer, though there have not been many reviews submitted so far.

Posted on 26th March 2008
Under: Uncategorized | No Comments »

Alpha and Beta Separation

Long only active portfolios have exposure to both beta (market return) and alpha (manager skill).  A long-short market neutral portfolio, by contrast, is designed to have no beta exposure.

Some investors prefer to separate alpha and beta by getting beta exposure from passive (indexed) strategies and alpha exposure from long-short market neutral portfolios. This offers several advantages:

  • Beta exposure can be obtained cheaply through indexed portfolios.
  • Fees paid for alpha can be explicitly specified
  • Broadens the opportunities to gain alpha
  • Allows mixing of alpha of one style or asset class with beta of another when a particular benchmark may offer few opportunities to generate alpha

Such strategies are often called portable alpha.

Posted on 25th March 2008
Under: Active Management, Hedge Funds, Institutional Investing, Passive Management, Portfolio Management | No Comments »

Measures of Risk for Fixed Income Portfolios

Standard Deviation

  • Assumes returns are normally distributed
  • Allows for probability distributions (confidence intervals)
  • Disadvantage is that returns are not normally distributed, particularly when the bonds have embedded options


  • Measures the dispersion of outcomes below the target rate of return
  • Theoretically superior to variance or standard deviation because most investors are concerned primarily about risk to the downside
  • Disadvantages:
    • Computationally challenging for large portfolios
    • If returns are symmetrical, it contains no additional information
    • If returns are not symmetrical, the return asymmetries are difficult to forecast
    • Use of only half the data reduces statistical accuracy

Shortfall risk

  • Relates to probability of failing to achieve the specified target
  • Disadvantage is that it does not account for the magnitude (in money terms) of losses

Value at Risk (VAR)

  • Estimates loss (in money terms) portfolio is likely to encounter over a specified time at a given level of probability
  • Disadvantage is that it does not indicate the magnitude of worst-case scenarios

Posted on 24th March 2008
Under: FInancial Planning, Fixed income investments, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Criteria For Selecting a Fixed Income Index

When choosing a benchmark index for a fixed income portfolio, the chosen benchmark should have characteristics that reflect those of the desired portfolio. Important factors to consider include market value risk, income risk and liability framework risk.

Market value risk is the reaction to changes in interest rates. Longer duration portfolios have more exposure to market value risk.

Income risk relates to how dependable is a portfolio’s income stream. This is a function of how long fixed payments can be assured. Shorter duration portfolios have more exposure to income risk.

Liability framework risk is a tiered approach that attempts to manage duration and other factors to the actual liabilities being managed.

Posted on 23rd March 2008
Under: Fixed income investments, Investing in bonds, Portfolio Management | No Comments »

Hedge Fund: Kurtosis Definition & Explanation : Hedge Fund

Written by Richard Wilson in his Hedge Fund Blog

Kurtosis Definition: In probability theory and statistics, kurtosis from the Greek word kurtos, meaning bulging is a measure of the “peakedness” of the probability distribution of a real-valued random variable. Higher kurtosis means more of the variance is due to infrequent extreme deviations, as opposed to frequent modestly-sized deviations.

The blue distribution exhibits higher kurtosis.

Posted on 22nd March 2008
Under: Quantitative Analysis | No Comments »