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vii
Contents
List of Tables and Examples xv
Preface xxi
Origins of the Book xxi
Objectives xxii
Scope xxii
The Cast xxiii
Overlap of Traditional and Quantitative xxiii
Case Studies xxiii
Spreadsheets xxiv
Glossary xxiv
Acknowledgements xxv
PART I INTRODUCTION
1 Introduction 3
What has Changed? 3
Defining the Investment Fund Structure 6
The Role of the Investment Consultant 8
The Investment Strategy 11
The Investment Management Mandate 17
Manager Selection 20
Portfolio Evaluation 21
The Role of the Custodian 22
2 The Traditional Approach 25
Allocation to Asset Classes 28
Security Selection within Asset Classes 31
Limitations of Traditional Approaches 33
Trends in Traditional Investment Management 34
3 Investment Management Theory 36
The Efficient Markets Hypothesis (EMH) 36
The Capital Asset Pricing Model (CAPM) 38
Optimal Portfolios and Portfolio Optimization 41
Expected and Observed Return and Risk 46
Value-at-Risk (VAR) 48
Risk Budgeting 49
Reverse Optimization 50
Interest Rates 51
PART II PORTFOLIO CONSTRUCTION
4 Quantitative Asset Allocation Models 55
Applications 55
Theory 56
Long-Term Asset Allocation 57
Short-Term Asset Allocation 75
Risk Management 78
Implementation of Short-term Asset Allocation 79
Use of Derivatives 83
Ongoing Management 84
Administration 85
Valuation 85
Performance Measurement and Attribution 87
Pitfalls 90
Case Study 90
5 Portfolio Protection 94
Applications 94
Theory 97
Option Pricing 100
Black–Scholes versus CPPI 105
Implementation 105
Ongoing Management 106
Currency Management 107
Administration 108
Valuation 108
Performance Measurement and Attribution 110
Pitfalls 110
The 1987 Market Crash 111
Case Study 113
6 Capital Guaranteed Portfolios 118
Applications 118
Theory 118
Implementation 120
viii CONTENTS
Currency Management 121
Ongoing Management 122
Administration 123
Valuation 124
Performance Measurement and Attribution 124
Pitfalls 124
Case Study 125
7 Passive Asset Allocation 128
Applications 128
Theory 129
Implementation 130
Currency Management 130
Use of Derivatives 131
Ongoing Management 132
Administration 134
Valuation 134
Performance Measurement and Attribution 134
Pitfalls 137
Case Study 137
8 Quantitative Models for Domestic Equity Portfolios 143
Applications 143
Theory 143
Defining the Benchmark 144
Return Forecasting 144
Risk Forecasting and Management 158
Currency Management 159
Implementation 160
Use of Derivatives 162
Corporate Actions 162
Ongoing Management 164
Administration 165
Valuation 165
Performance Measurement and Attribution 166
Pitfalls 167
Case Study 168
9 Quantitative Models for International Equity Portfolios 173
Applications 173
Theory 174
Defining the Benchmark 175
Return Forecasting 175
Implementation 187
Ongoing Management 190
Use of Derivatives 191
Administration 192
CONTENTS ix
Valuation 192
Performance Measurement and Attribution 192
Pitfalls 195
Case Study 196
10 Optimized Stock Selection Models 200
Applications 200
Theory 201
Optimizers for Asset Allocation and Stock Selection 203
Estimating the Risk Factor Model 203
The Relationship Between Stock Selection and
Asset Allocation 208
Applying Global Factors 211
Portfolio Risk Analysis 213
Portfolio Construction 216
Currency Management 219
Use of Derivatives 219
Ongoing Management and Administration 220
Performance Measurement and Attribution 220
Reverse Optimization 220
Pitfalls 223
11 Indexation 225
Applications 225
Theory 226
Defining the Benchmark 228
Currency Management 235
Use of Derivatives 235
Index Enhancements 236
Customized Indexed Portfolios 240
Indexation of Domestic Fixed Interest Portfolios 241
Indexation of International Fixed Interest Portfolios 243
Indexation of Property Portfolios 243
Ongoing Management 243
Administration 245
Valuation 245
Performance Measurement and Attribution 246
Pitfalls 248
Case Study 248
12 Fixed Interest Portfolios 252
Applications 252
Theory 253
Calculating the Price of Fixed Interest Securities 255
Credit Risk 259
Portfolio Construction 262
x CONTENTS
Interest Rate Risk Management 263
Yield Curve Modelling 267
Implementation 269
Use of Derivatives 270
Currency Management 271
Ongoing Management 272
Administration 273
Valuation 273
Performance Measurement and Attribution 274
Pitfalls 274
Case Study 275
13 Property Portfolios 277
Applications 277
Theory 277
Implementation 278
Use of Derivatives 280
Ongoing Management 281
Administration 282
Valuation 282
Performance Measurement and Attribution 283
Pitfalls 285
Case Study 286
14 Market Neutral (Hedge) Portfolios and Other Alternative
Investment Classes 288
Characteristics of Alternative Investment Funds 288
Applications 290
Theory 291
Alternative Investment Strategies 291
Implementation 300
Currency Management 301
Ongoing Management 302
Administration 303
Valuation 303
Performance Measurement and Attribution 304
Pitfalls 305
Case Study 305
15 Portfolio Transition and Transition Portfolios 310
Portfolio Transition 310
Transition Management 312
Transition Portfolios 314
Objectives 314
Implementation 315
Currency Management 316
CONTENTS xi
Ongoing Management 317
Administration 317
Valuation 317
Performance Measurement and Attribution 318
Pitfalls 318
Case Study 320
16 Currency Management 322
Applications 322
Theory 324
Approaches to Active Currency Management 327
Defining the Currency Management Mandate 329
Implementation 330
Use of Derivatives 331
Ongoing Management 331
Administration 332
Valuation 333
Performance Measurement and Attribution 334
Pitfalls 335
PART III PERIPHERALS
17 Implementation of Equity Portfolios 339
The Traditional Approach 339
Basket Trading 342
Stock Borrowing and Lending 344
Soft Dollars 346
Directed Commissions 348
18 Performance Measurement and Attribution 350
Single Period Return Measurement 350
Multiple Period Return Measurement 354
The Limitations of Returns 355
Single Period Attribution Analysis 358
Analysis of Deadweight and Active Holdings 361
Multiple Period Attribution Analysis 362
19 The Use of Software in Investment Management 366
Market Information 367
Return Forecasting for Asset Classes and Individual Securities 368
Risk Modelling, Portfolio Analysis and Construction 368
Analysis of Derivatives 371
Recording and Reconciling Transactions 372
Maintaining Portfolio Records 374
Tax 374
Portfolio Valuation 375
xii CONTENTS
Return Measurement, Attribution and Reporting 377
Buy versus Build 378
Integrated versus Cherry-picking with Middleware 379
20 Trends in Investment Management 380
Ownership and Structure of Investment
Management Firms 380
Boutiques versus Full Service Managers 381
Fee Structures 382
The Custodian as Investment Manager 384
The Role of the Consultant 385
Corporate Governance 386
The Role of the Compliance Officer 388
People versus Processes: Atomization of Investment
Management Functions 390
21 Conclusions: Traditional versus Quantitative 393
Models for Investment Management 394
Traditional versus Quantitative Investment Management 396
The Grey Areas 398
PART IV APPENDICES
Appendix 1: Pricing Interest Rate Securities 403
The Settlement Value of a Discount Security 403
The Point Value of a Discount Security 404
The Settlement Value of a Bond 405
The Point Value of a Bond 406
Appendix 2: Forward Contracts 407
Theory 407
Pricing 408
Foreign Exchange Forwards 410
Interest Rate Forwards 411
Implementation 413
Ongoing Management 415
Administration 416
Appendix 3: Futures Contracts 418
Theory 418
Pricing 418
Applications 419
Futures on Discount Interest-bearing Securities 420
Futures on Bonds 421
Pricing a Bond Future 422
Implementation 422
CONTENTS xiii
Ongoing Management 425
Administration 426
Performance Measurement and Attribution 428
Appendix 4: Swaps 431
Theory 431
Pricing 433
Implementation 434
Administration 435
Performance Attribution 436
Synthetic Swaps 436
Advantages and Disadvantages of Swaps Over Futures and Forwards 439
Appendix 5: Options 440
Pricing 441
Options on Futures 442
Assumptions 445
Put–call Parity 445
Option Volatility – Gamma 450
Implied Volatility 452
Implementation 452
Options on Physical Securities 453
Over-the-counter 453
Ongoing Management 454
Administration 455
Performance Measurement and Attribution 455
Appendix 6: Convertible and Converting Notes 457
Theory 457
Pricing 458
Convertible Notes 458
Converting Notes 461
Applications 462
Implementation 463
Ongoing Management 463
Administration 464
Performance Measurement and Attribution 464
Glossary of Terms 467
Bibliography 490
Index 492