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CHAPTER 4

PORTFOLIO MANAGEMENT: AN OVERVIEW

Robert M. Conroy, CFA

Charlottesville, VA, U.S.A.

Alistair Byrne, CFA

Edinburgh, U.K.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Explain the importance of the portfolio perspective.
• Discuss the types of investment management clients and the distinctive characteristics and needs of each.
• Describe the steps in the portfolio management process.
• Describe, compare, and contrast mutual funds and other forms of pooled investments.

1. INTRODUCTION

In this chapter we explain why the portfolio approach is important to all types of investors in achieving their financial goals. We compare the financial needs of different types of individual and institutional investors. After we outline the steps in the portfolio management process, we compare and contrast the types of investment management products that are available to investors and how they apply to the portfolio approach.

2. A PORTFOLIO PERSPECTIVE ON INVESTING

One of the biggest challenges faced by individuals and institutions is to decide how to invest for future needs. For individuals, the goal might be to fund retirement needs. For such institutions as insurance companies, the goal is to fund future liabilities in the form of insurance claims, whereas endowments seek to provide income to meet the ongoing needs of such institutions as universities. Regardless of the ultimate goal, all face the same set of challenges that extend beyond just the choice of what asset classes to invest in. They ultimately center on formulating basic principles that determine how to think about investing. One important question is: Should we invest in individual securities, evaluating each in isolation, or should we take a portfolio approach? By “portfolio approach,” we mean evaluating individual securities in relation to their contribution to the investment characteristics of the whole portfolio. In the following section, we illustrate a number of reasons why a diversified portfolio perspective is important.

2.1. Portfolio Diversification: Avoiding Disaster

Portfolio diversification helps investors avoid disastrous investment outcomes. This benefit is most convincingly illustrated by examining what may happen when individuals have not diversified.

We are usually not able to observe how individuals manage their personal investments. However, in the case of U.S. 401(k) individual retirement portfolios,1 it is possible to see the results of individuals’ investment decisions. When we examine their retirement portfolios, we find that some individual participants make suboptimal investment decisions.

During the 1990s, Enron Corporation was one of the most admired corporations in the United States. A position in Enron shares returned over 27 percent per year from 1990 to September 2000, compared to 13 percent for the S&P 500 Index for the same time period (see Exhibit 4-1).

During this time period, thousands of Enron employees participated in the company’s 401(k) retirement plan. The plan allowed employees to set aside some of their earnings in a tax-deferred account. Enron participated by matching the employees’ contributions. Enron made the match by depositing required amounts in the form of Enron shares. Enron restricted the sale of its contributed shares until an employee turned 50 years old. In January 2001, the employees’ 401(k) retirement accounts were valued at over US$2 billion, of which US$1.3 billion (or 62 percent) was in Enron shares. Although Enron restricted the sale of shares it contributed, less than US$150 million of the total of US$1.3 billion in shares had this restriction. The implication was that Enron employees continued to hold large amounts of Enron shares even though they were free to sell them and invest the proceeds in other assets.

A typical individual was Roger Bruce,2 a 67-year-old Enron retiree who held all of his US$2 million in retirement funds in Enron shares. Unlike most stories, this one does not have a happy ending. Between January 2001 and January 2002, Enron’s share price fell from about US$90 per share to zero (see Exhibit 4-2).

Employees and retirees who had invested all or most of their retirement savings in Enron shares, just like Mr. Bruce, experienced financial ruin. The hard lesson that the Enron employees learned from this experience was to “not put all your eggs in one basket.”3 Unfortunately, the typical Enron employee did have most of his or her eggs in one basket. Most employees’ wages and financial assets were dependent on Enron’s continued viability; hence, any financial distress on Enron would have a material impact on an employee’s financial health. The bankruptcy of Enron resulted in the closing of its operations, the dismissal of thousands of employees, and its shares becoming worthless. Hence, the failure of Enron was disastrous to the typical Enron employee.

Enron employees were not the only ones to be victims of overinvestment in a single company’s shares. Another form of pension arrangement in many corporations is the defined contribution plan, in which the employer makes periodic cash contributions to a retirement fund managed by the employees themselves instead of guaranteeing a certain pension at retirement. In the defined contribution retirement plans at Owens Corning, Northern Telecom, Corning, and ADC Telecommunications, employees all held more than 25 percent of their assets in the company’s shares during a time (March 2000 to December 2001) in which the share prices in these companies fell by almost 90 percent. The good news in this story is that the employees participating in employer-matched 401(k) plans since 2001 have significantly reduced their holdings of their employers’ shares.

Thus, by taking a diversified portfolio approach, investors can spread away some of the risk. All rational investors are concerned about the risk–return trade off of their investments. The portfolio approach provides investors with a way to reduce the risk associated with their wealth without necessarily decreasing their expected rate of return.

2.2. Portfolios: Reduce Risk

In addition to avoiding a potential disaster associated with overinvesting in a single security, portfolios also generally offer equivalent expected returns with lower overall volatility of returns—as represented by a measure such as standard deviation. Consider this simple example: Suppose you wish to make an investment in companies listed on the Hong Kong Stock Exchange (HKSE) and you start with a sample of five companies.4 The cumulative returns for the five companies from Q2 2004 through Q2 2008 are shown in Exhibit 4-3.

The individual quarterly returns for each of the five shares are shown in Exhibit 4-4. The annualized means and annualized standard deviations for each are also shown.5

EXHIBIT 4-4 Quarterly Returns (in percent) for Sample of HKSE Listed Shares, End of Q2 2004−End of Q2 2008

Source for data: Datastream.

Suppose you want to invest in one of these five securities next year. There is a wide variety of risk–return trade-offs for the five shares selected. If you believe that the future will replicate the past, then choosing Li & Fung would be a good choice. For the prior four years, Li & Fung provided the best trade-off between return and risk. In other words, it provided the most return per unit of risk. However, if there is no reason to believe that the future will replicate the past, it is more likely that the risk and return on the one security selected will be more like selecting one randomly. When we randomly selected one security each quarter, we found an average annualized return of 15.1 percent and an average annualized standard deviation of 24.9 percent, which would now become your expected return and standard deviation, respectively.

Alternatively, you could invest in an equally weighted portfolio of the five shares, which means that you would invest the same dollar amount in each security for each quarter. The quarterly returns on the equally weighted portfolio are just the average of the returns of the individual shares. As reported in Exhibit 4-4, the equally weighted portfolio has an average return of 15.1 percent and a standard deviation of 17.9 percent. As expected, the equally weighted portfolio’s return is the same as the return on the randomly selected security. However, the same does not hold true for the portfolio standard deviation. That is, the standard deviation of an equally weighted portfolio is not simply the average of the standard deviations of the individual shares. In a later chapter we will demonstrate in greater mathematical detail how such a portfolio offers a lower standard deviation of return than the average of its individual components due to the correlations or interactions between the individual securities.

Because the mean return is the same, a simple measure of the value of diversification is calculated as the ratio of the standard deviation of the equally weighted portfolio to the standard deviation of the randomly selected security. This ratio may be referred to as the diversification ratio. In this case, the equally weighted portfolio’s standard deviation is approximately 71 percent of that of a security selected at random. The diversification ratio of the portfolio’s standard deviation to the individual asset’s standard deviation measures the risk reduction benefits of a simple portfolio construction method, equal weighting. Even though the companies were chosen from a similar industry grouping, we see significant risk reduction. An even greater portfolio effect (i.e., lower diversification ratio) could have been realized if we had chosen companies from completely different industries.

This example illustrates one of the critical ideas about portfolios: Portfolios affect risk more than returns. In the prior section portfolios helped avoid the effects of downside risk associated with investing in a single company’s shares. In this section we extended the notion of risk reduction through portfolios to illustrate why individuals and institutions should hold portfolios.

2.3. Portfolios: Composition Matters for the Risk–Return Tradeoff

In the previous section we compared an equally weighted portfolio to the selection of a single security. In this section we examine additional combinations of the same set of shares and observe the trade-offs between portfolio volatility of returns and expected return (for short, their risk–return trade-offs). If we select the portfolios with the best combination of risk and return (taking historical statistics as our expectations for the future), we produce the set of portfolios shown in Exhibit 4-5.

In addition to illustrating that the diversified portfolio approach reduces risk, Exhibit 4-5 also shows that the composition of the portfolio matters. For example, an equally weighted portfolio (20 percent of the portfolio in each security) of the five shares has an expected return of 15.1 percent and a standard deviation of 17.9 percent. Alternatively, a portfolio with 25 percent in Yue Yuen Industrial (Holdings), 3 percent in Cathay Pacific, 52 percent in Hutchison Whampoa, 20 percent in Li & Fung, and 0 percent in COSCO Pacific produces a portfolio with an expected return of 15.1 percent and a standard deviation of 15.6 percent. Compared to a simple equally weighted portfolio, this provides an improved tradeoff between risk and return because a lower level of risk was achieved for the same level of return.

2.4. Portfolios: Not Necessarily Downside Protection

A major reason that portfolios can effectively reduce risk is that combining securities whose returns do not move together provides diversification. Sometimes a subset of assets will go up in value at the same time that another will go down in value. The fact that these may offset each other creates the potential diversification benefit we attribute to portfolios. However, an important issue is that the co-movement or correlation pattern of the securities’ returns in the portfolio can change in a manner unfavorable to the investor. We use historical return data from a set of global indices to show the impact of changing co-movement patterns.

When we examine the returns of a set of global equity indices over the past 15 years, we observe a reduction in the diversification benefit due to a change in the pattern of co-movements of returns. Exhibits 4-6 and 4-7 show the cumulative returns for a set of five global indices6 for two different time periods. Comparing the first time period, from Q4 1993 through Q3 2000 (as shown in Exhibit 4-6), with the last time period, from Q1 2006 through Q1 2009 (as shown in Exhibit 4-7), we show that the degree to which these global equity indices move together has increased over time.

The latter part of the second time period, from Q4 2007 to Q1 2009, was a period of dramatic declines in global share prices. Exhibit 4-8 shows the mean annual returns and standard deviation of returns for this time period.

EXHIBIT 4-8 Returns to Global Equity Indices

Source for data: Datastream.

During the period Q4 2007 through Q1 2009, the average return for the equally weighted portfolio, including dividends, was −48.5 percent. Other than reducing the risk of earning the return of the worst performing market, the diversification benefits were small. Exhibit 4-9 shows the cumulative quarterly returns of each of the five indices over this time period. All of the indices declined in unison. The lesson is that although portfolio diversification generally does reduce risk, it does not necessarily provide the same level of risk reduction during times of severe market turmoil as it does when the economy and markets are operating “normally.” In fact, if the economy or markets fail totally (which has happened numerous times around the world), then diversification is a false promise. In the face of a worldwide contagion, diversification was ineffective, as illustrated at the end of 2008.

2.5. Portfolios: The Emergence of Modern Portfolio Theory

The concept of diversification has been around for a long time and has a great deal of intuitive appeal. However, the actual theory underlying this basic concept and its application to investments only emerged in 1952 with the publication of Harry Markowitz’s classic article on portfolio selection.7 The article provided the foundation for what is now known as modern portfolio theory (MPT). The main conclusion of MPT is that investors should not only hold portfolios but should also focus on how individual securities in the portfolios are related to one another. In addition to the diversification benefits of portfolios to investors, the work of William Sharpe (1964), John Lintner (1965), and Jack Treynor (1961) demonstrated the role that portfolios play in determining the appropriate individual asset risk premium (i.e., the return in excess of the risk-free return expected by investors as compensation for the asset’s risk). According to capital market theory, the priced risk of an individual security is affected by holding it in a well-diversified portfolio. The early research provided the insight that an asset’s risk should be measured in relation to the remaining systematic or nondiversifiable risk, which should be the only risk that affects the asset’s price. This view of risk is the basis of the capital asset pricing model, or CAPM. Although MPT has limitations, the concepts and intuitions illustrated in the theory continue to be the foundation of knowledge for portfolio managers.

3. INVESTMENT CLIENTS

Portfolio managers are employed or contracted by a wide variety of investment clients. We can group the clients into categories based on their distinctive characteristics and needs. Our initial distinction is between management of the private wealth of individual investors and investment management for institutional investors.

3.1. Individual Investors

Individual investors have a variety of motives for investing and constructing portfolios. Short-term goals can include providing for children’s education, saving for a major purchase (such as a vehicle or a house), or starting a business. The retirement goal—investing to provide for an income in retirement—is a major part of the investment planning of most individuals. Many employees of public and private companies invest for retirement through a defined contribution (DC) pension plan. A DC plan is a pension plan in which contributions rather than benefits are specified, such as 401(k) plans in the United States, group personal pension schemes in the United Kingdom, and superannuation plans in Australia. Individuals will invest part of their wages while working, expecting to draw on the accumulated funds to provide income during retirement or to transfer some of their wealth to their heirs. The key to a DC plan is that the employee accepts the investment risk and is responsible for ensuring that there are enough funds in the plan to meet their needs upon retirement.

Some individuals will be investing for growth and will therefore seek assets that have the potential for capital gains. Others, such as retirees, may need to draw an income from their assets and may therefore choose to invest in fixed-income and dividend-paying shares. The investment needs of individuals will depend in part on their broader financial circumstances, such as their employment prospects and whether or not they own their own residence. They may also need to consider such issues as building up a cash reserve and the purchase of appropriate insurance policies before undertaking longer-term investments.

3.2. Institutional Investors

There are many different types of institutional investors. Examples include defined benefit pensions plans, university endowments, charitable foundations, banks, insurance companies, investment companies, and sovereign wealth funds (SWFs). Institutional investors are major participants in the investment markets. Exhibit 4-10 shows the relative size and growth rates of the key categories across the Organisation for Economic Co-operation and Development (OECD) countries. Investment funds are the largest category, with insurance companies and pension funds not far behind. The relative importance of these categories does vary significantly across the individual OECD countries.

3.2.1. Defined Benefit Pension Plans

In a defined benefit (DB) pension plan, an employer has an obligation to pay a certain annual amount to its employees when they retire. In other words, the future benefit is defined because the DB plan requires the plan sponsor to specify the obligation stated in terms of the retirement income benefits owed to participants. DB plans need to invest the assets that will provide cash flows that match the timing of the future pension payments (i.e., liabilities). Plans are committed to paying pensions to members, and the assets of these plans are there to fund those payments. Plan managers need to ensure that sufficient assets will be available to pay pension benefits as they come due. The plan may have an indefinitely long time horizon if new plan members are being admitted or a finite time horizon if the plan has been closed to new members. Even a plan closed to new members may still have a time horizon of 70 or 80 years. For example, a plan member aged 25 may not retire for another 40 years and may live 30 years in retirement. Hence, pension plans can be considered long-term investors. In some cases, the plan managers attempt to match the fund’s assets to its liabilities by, for example, investing in bonds that will produce cash flows corresponding to expected future pension payments. There may be many different investment philosophies for pension plans, depending on funded status and other variables.

3.2.2. Endowments and Foundations

University endowments are established to provide continuing financial support to a university and its students (e.g., scholarships). Endowments vary in size (assets under management), but many are major investors. It is common for U.S. universities to have large endowments, but it is somewhat less common elsewhere in the world. Exhibit 4-11 shows the top ten U.S. university endowments by assets as of the end of 2008. In terms of non-U.S. examples, the University of Oxford, United Kingdom, and its various colleges were estimated to have a total endowment of £4.8 billion as of 2004 and the University of Cambridge, United Kingdom, and its colleges, £5.3 billion. These were by far the largest endowments in the United Kingdom. The third largest, University of Edinburgh, was £156 million.8 The French business school INSEAD’s endowment was valued at €105 million as of 2008.9

EXHIBIT 4-11 Top Ten U.S. University Endowments by Asset Value

Source: NACUBO, “2008 NACUBO Endowment Study” (January 2009): www.nacubo.org/Research/NACUBO_Endowment_Study.html.

Charitable foundations invest donations made to them for the purpose of funding grants that are consistent with the charitable foundation’s objectives. Similar to university endowments, many charitable foundations are substantial investors. Exhibit 4-12 lists U.S. grant-making foundations ranked by the market value of their assets based on the most current audited financial data in the Foundation Center’s database as of 5 February 2009. Again, large foundations are most common in the United States, but they also exist elsewhere. For example, the Wellcome Trust is a U.K.-based medical charity that had approximately £13 billion of assets as of 2008.10 The Li Ka Shing Foundation is a Hong Kong–based education and medical charity with grants, sponsorships, and commitments amounting to HK$10.7 billion.

EXHIBIT 4-12 Top Ten U.S. Foundation Endowments by Asset Value

Source: Foundation Center (2009): http://foundationcenter.org.

A typical investment objective of an endowment or a foundation is to maintain the real (inflation-adjusted) capital value of the fund while generating income to fund the objectives of the institution. Most foundations and endowments are established with the intent of having perpetual lives. Example 4-1 describes the US$22 billion Yale University endowment’s approach to balancing short-term spending needs with ensuring that future generations also benefit from the endowment, and it also shows the £13 billion Wellcome Trust’s approach. The investment approach undertaken considers the objectives and constraints of the institution (for example, no tobacco investments for a medical endowment).

3.2.3. Banks

Banks typically accept deposits and extend loans. In some cases, banks need to invest their excess reserves (i.e., when deposits have not been used to make loans). The investments of excess reserves need to be conservative, emphasizing fixed-income and money market instruments rather than equities and other riskier assets. In some countries, including the United States, there are legal restrictions on banks owning equity investments.11 In addition to low risk, the investments also need to be relatively liquid so that they can be sold quickly if depositors wish to withdraw their funds. The bank’s objective is to earn a return on its reserves that exceeds the rate of interest it pays on its deposits.

3.2.4. Insurance Companies

Insurance companies receive premiums for the policies they write, and they need to invest these premiums in a manner that will allow them to pay claims. Similar to banks, such investments need to be relatively conservative given the necessity of paying claims when due. Life insurance companies and non-life insurance companies (for example, auto and home insurance) differ in their purpose and objectives and hence in their investment time horizons. Life insurance companies have longer time horizons than non-life insurance companies as a result of different expectations of when payments will be required under policies.

3.2.5. Investment Companies

Investment companies that manage mutual funds are also institutional investors. The mutual fund is a collective financial institution in which investors pool their capital to have it invested by a professional manager. The investors own shares or units in the fund. For many investment managers, the mutual fund is, in effect, their client. However, mutual funds are slightly different in that they can also be considered a financial product. For many individual investors, the mutual fund is an efficient means to benefit from portfolio diversification and the skill of a professional manager. The mutual fund is likely to invest in a particular category of investments, such as U.S. small capitalization equities. Mutual funds may also have certain limits and restrictions that apply to their investments, either as set by regulation and law or as decided by the board of directors of the investment company. We will revisit these investment vehicles in greater detail when we discuss pooled investments in Section 5.

3.2.6. Sovereign Wealth Funds

Sovereign wealth funds (SWFs) are government-owned investment funds, of which many are very sizable. For example, the largest SWF, managed by Abu Dhabi Investment Authority, is funded with oil revenues that amounted to US$627 billion12 as of March 2009. Exhibit 4-13 provides a listing of the top 10 sovereign wealth funds as of March 2009.

EXHIBIT 4-13 Sovereign Wealth Funds by Asset Value

Source: SWF Institute (www.swfinstitute.org).

Some funds have been established to invest revenues from finite natural resources (e.g., oil) for the benefit of future generations of citizens. Others manage foreign exchange reserves or other assets of the state. Some funds are quite transparent in nature—disclosing their investment returns and their investment holdings—whereas relatively little is known about the investment operations of others.

Exhibit 4-14 summarizes how investment needs vary across client groups. In some cases, generalizations are possible. In others, needs vary by client.

EXHIBIT 4-14 Summary of Investment Needs by Client Type

4. STEPS IN THE PORTFOLIO MANAGEMENT PROCESS

In the previous section we discussed the different types of investment management clients and the distinctive characteristics and needs of each. The following steps in the investment process are critical in the establishment and management of a client’s investment portfolio.

• The Planning Step
  • Understanding the client’s needs.
  • Preparation of an investment policy statement (IPS).
• The Execution Step
  • Asset allocation.
  • Security analysis.
  • Portfolio construction.
• The Feedback Step
  • Portfolio monitoring and rebalancing.
  • Performance measurement and reporting.

4.1. Step One: The Planning Step

The first step in the investment process is to understand the client’s needs (objectives and constraints) and develop an investment policy statement (IPS). A portfolio manager is unlikely to achieve appropriate results for a client without a prior understanding of the client’s needs. The IPS is a written planning document that describes the client’s investment objectives and the constraints that apply to the client’s portfolio. The IPS may state a benchmark—such as a particular rate of return or the performance of a particular market index—that can be used in the feedback stage to assess the performance of the investments and whether objectives have been met. The IPS should be reviewed and updated regularly (for example, either every three years or when a major change in a client’s objectives, constraints, or circumstances occurs).

4.2. Step Two: The Execution Step

The next step is for the portfolio manager to construct a suitable portfolio based on the IPS of the client. The portfolio execution step consists of first deciding on a target asset allocation, which determines the weighting of asset classes to be included in the portfolio. This step is followed by the analysis, selection, and purchase of individual investment securities.

4.2.1. Asset Allocation

The next step in the process is to assess the risk and return characteristics of the available investments. The analyst forms economic and capital market expectations that can be used to form a proposed allocation of asset classes suitable for the client. Decisions that need to be made in the asset allocation of the portfolio include the distribution between equities, fixed-income securities, and cash; subasset classes, such as corporate and government bonds; and geographical weightings within asset classes. Alternative assets—such as real estate, commodities, hedge funds, and private equity—may also be included.

Economists and market strategists may set the top down view on economic conditions and broad market trends. The returns on various asset classes are likely to be affected by economic conditions; for example, equities may do well when economic growth has been unexpectedly strong whereas bonds may do poorly if inflation increases. The economists and strategists will attempt to forecast these conditions.

4.2.2. Security Analysis

The top down view can be combined with the bottom up insights of security analysts who are responsible for identifying attractive investments in particular market sectors. They will use their detailed knowledge of the companies and industries they cover to assess the expected level and risk of the cash flows that each security will produce. This knowledge allows the analysts to assign a valuation to the security and identify preferred investments.

4.2.3. Portfolio Construction

The portfolio manager will then construct the portfolio, taking account of the target asset allocation, security analysis, and the client’s requirements as set out in the IPS. A key objective will be to achieve the benefits of diversification (i.e., to avoid putting all the eggs in one basket). Decisions need to be taken on asset class weightings, sector weightings within an asset class, and the selection and weighting of individual securities or assets. The relative importance of these decisions on portfolio performance depends at least in part on the investment strategy selected; for example, consider an investor that actively adjusts asset sector weights in relation to forecasts of sector performance and one who does not. Although all decisions have an effect on portfolio performance, the asset allocation decision is commonly viewed as having the greatest impact.

Exhibit 4-15 shows the broad portfolio weights of the endowment funds of Yale University and the University of Virginia as of June 2008. As you can see, the portfolios have a heavy emphasis on such alternative assets as hedge funds, private equity, and real estate—Yale University particularly so.

EXHIBIT 4-15 Endowment Portfolio Weights, June 2008

Note: The negative cash positions indicate that at the point the figures were taken, the funds had net borrowing rather than net cash.

Sources: “2008 Yale Endowment Annual Report” (p. 2): www.yale.edu/investments/Yale_Endowment_08.pdf, “University of Virginia Investment Management Company Annual Report 2008” (p. 16): http://uvm-web.eservices.virginia.edu/public/reports/FinancialStatements_2008.pdf.

Asset Class	Yale University Endowment	University of Virginia Endowment
Public equity	25.3%	53.6%
Fixed income	4.0	15.0
Private equity	20.2	19.6
Real assets (e.g., real estate)	29.3	10.1
Absolute return (e.g., hedge funds)	25.1	8.1
Cash	−3.9	−6.5
Portfolio value	US$22.9bn	US$5.1bn

Risk management is an important part of the portfolio construction process. The client’s risk tolerance will be set out in the IPS, and the portfolio manager must make sure the portfolio is consistent with it. As noted previously, the manager will take a diversified portfolio perspective: What is important is not the risk of any single investment, but rather how all the investments perform as a portfolio.

The endowments just shown are relatively risk tolerant investors. Contrast the asset allocation of the endowment funds with the portfolio mix of the insurance companies shown in Exhibit 4-16. You will notice that the majority of the insurance assets are invested in fixed-income investments, typically of high quality. Note that the Yale University portfolio has only 4 percent invested in fixed income, with the remainder invested in such growth assets as equity, real estate, and hedge funds. This allocation is in sharp contrast to the Massachusetts Mutual Life Insurance Company (MassMutual) portfolio, which is over 80 percent invested in bonds, mortgages, loans, and cash—reflecting the differing risk tolerance and constraints (life insurers face regulatory constraints on their investments).

EXHIBIT 4-16 Insurance Company Portfolios, December 200813

Note: MetLife is the Metropolitan Life Insurance Company.

Sources: “MassMutual Financial Group 2008 Annual Report” (p. 26): www.massmutual.com/mmfg/docs/annual_report/index.html, “MetLife 2008 Annual Report” (p. 83): http://investor.metlife.com/phoenix.zhtml?c=121171&p=irol-reportsannual.

Asset Classes	MassMutual Portfolio	MetLife Portfolio
Bonds	56.4%	58.7%
Preferred and common shares	2.2	1.0
Mortgages	15.1	15.9
Real estate	1.3	2.4
Policy loans	10.6	3.0
Partnerships	6.4	1.9
Other assets	4.5	5.3
Cash	3.5	11.8

The portfolio construction phase also involves trading. Once the portfolio manager has decided which securities to buy and in what amounts, the securities must be purchased. In many investment firms, the portfolio manager will pass the trades to a buy side trader—a colleague who specializes in securities trading—who will contact a stockbroker or dealer to have the trades executed.

4.3. Step Three: The Feedback Step

Finally, the feedback step assists the portfolio manager in rebalancing the portfolio due to a change in, for example, market conditions or the circumstances of the client.

4.3.1. Portfolio Monitoring and Rebalancing

Once the portfolio has been constructed, it needs to be monitored and reviewed and the composition revised as the security analysis changes because of changes in security prices and changes in fundamental factors. When security and asset weightings have drifted from the intended levels as a result of market movements, some rebalancing may be required. The portfolio may also need to be revised if it becomes apparent that the client’s needs or circumstances have changed.

4.3.2. Performance Measurement and Reporting

Finally, the performance of the portfolio must be measured, which will include assessing whether the client’s objectives have been met. For example, the investor will wish to know whether the return requirement has been achieved and how the portfolio has performed relative to any benchmark that has been set. Analysis of performance may suggest that the client’s objectives need to be reviewed and perhaps changes made to the IPS. As we will discuss in the next section, there are numerous investment products that clients can use to meet their investment needs. Many of these products are diversified portfolios that an investor can purchase.

5. POOLED INVESTMENTS

The challenge faced by all investors is finding the right set of investment products to meet their needs. Just as there are many different types of investment management clients, there is a diverse set of investment products available to investors. These vary from a simple brokerage account in which the individual creates her own portfolio by assembling individual securities, to large institutions that hire individual portfolio managers for all or part of their investment management needs. Although the array of products is staggering, there are some general categories of pooled investment products that represent the full range of what is available. At one end are mutual funds and exchange-traded funds in which investors can participate with a small initial investment. At the other end are hedge funds and private equity funds, which might require a minimum investment of US$1 million or more. In this context, the amount of funds that an individual or institution can commit to a particular product has a significant impact on which products are available. Exhibit 4-17 provides a general breakdown of what investment products are available to investors based on investable funds.

EXHIBIT 4-17 Investment Products by Minimum Investment

Mutual funds Exchange-traded funds	Mutual funds Exchange-traded funds Separately managed accounts	Mutual funds Exchange-traded funds Separately managed accounts Hedge funds Private equity funds
As little as US$50 Minimum Investment	US$100,000	US$1,000,000+

5.1. Mutual Funds

Rather than assemble a portfolio on their own, individual investors and institutions can turn over the selection and management of their investment portfolio to a third party. One alternative is a mutual fund. This type of fund is a comingled investment pool in which investors in the fund each have a pro-rata claim on the income and value of the fund. The value of a mutual fund is referred to as the “net asset value.” It is computed daily based on the closing price of the securities in the portfolio. At the end of the third quarter of 2008,14 the Investment Company Institute reported over 48,000 mutual funds in over 23 countries with a total net asset value of approximately US$20 trillion. Exhibit 4-18 shows the breakdown of mutual fund assets across the major regions of the world as of the end of 2007.

Mutual funds are one of the most important investment vehicles for individuals and institutions. The best way to understand how a mutual fund works is to consider a simple example. Suppose that an investment firm wishes to start a mutual fund with a target amount of US$10 million. It is able to reach this goal through investments from five individuals and two institutions. The investment of each is as follows:

Based on the US$10 million value (net asset value), the investment firm sets a total of 100,000 shares at an initial value of US$100 per share (US$10 million/100,000 = US$100). The investment firm will appoint a portfolio manager to be responsible for the investment of the US$10 million. Going forward, the total value of the fund or net asset value will depend on the value of the assets in the portfolio.

The fund can be set up as an open-end fund or a closed-end fund. If it is an open-end fund, it will accept new investment money and issue additional shares at a value equal to the net asset value of the fund at the time of investment. For example, assume that at a later date the net asset value of the fund increases to US$12.0 million and the new net asset value per share is US$120. A new investor, F, wishes to invest US$0.96 million in the fund. If the total value of the assets in the fund is now US$12 million or US$120 per share, in order to accommodate the new investment the fund would create 8,000 (US$0.96 million/US$120) new shares. After this investment, the net asset value of the fund would be US$12.96 million and there would be a total of 108,000 shares.

Funds can also be withdrawn at the net asset value per share. Suppose on the same day Investor E wishes to withdraw all her shares in the mutual fund. To accommodate this withdrawal, the fund will have to liquidate US$0.6 million in assets to retire 5,000 shares at a net asset value of US$120 per share (US$0.6 million/US$120). The combination of the inflow and outflow on the same day would be as follows:

Type	Investment (US$)	Shares
Inflow (Investor F buys)	+$960,000	+8,000
Outflow (Investor E sells)	−$600,000	−5,000
Net	+$360,000	+3,000

The net of the inflows and outflows on that day would be US$360,000 of new funds to be invested and 3,000 new shares created. However, the number of shares held and the value of the shares of all remaining investors, except Investor E, would remain the same.

An alternative to setting the fund up as an open-end fund would be to create a closed-end fund in which no new investment money is accepted into the fund. New investors invest by buying existing shares, and investors in the fund liquidate by selling their shares to other investors. Hence, the number of outstanding shares does not change. One consequence of this fixed share base is that, unlike open-end funds in which new shares are created and sold at the current net asset value per share, closed-end funds can sell for a premium or discount to net asset value depending on the demand for the shares.

There are advantages and disadvantages to each type of fund. The open-end fund structure makes it easy to grow in size but creates pressure on the portfolio manager to manage the cash inflows and outflows. One consequence of this structure is the need to liquidate assets that the portfolio manager might not want to sell at the time to meet redemptions. Conversely, the inflows require finding new assets in which to invest. As such, open-end funds tend not to be fully invested but rather keep some cash for redemptions not covered by new investments. Closed-end funds do not have these problems, but they do have a limited ability to grow. Of the total net asset value of all U.S. mutual funds at the end of 2008 (US$9.6 trillion), only approximately 2 percent were in the form of closed-end funds.

In addition to open-end or closed-end funds, mutual funds can be classified as load or no-load funds. The primary difference between the two is how the fund’s management is compensated. In the case of the no-load fund, there is no fee for investing in the fund or for redemption but there is an annual fee based on a percentage of the fund’s net asset value. Load funds are funds in which, in addition to the annual fee, a percentage fee is charged to invest in the fund and/or for redemptions from the fund. In addition, load funds are usually sold through retail brokers who receive part of the up-front fee. Overall, the number and importance of load funds has declined over time.

Mutual funds also differ in terms of the type of assets that they invest in. Broadly speaking, there are four different types of funds that are differentiated by broad asset type: stock funds (domestic and international), bond funds (taxable and nontaxable), hybrid or balanced funds (combination of stocks and bonds), and money market funds (taxable and nontaxable). The approximately US$9.6 trillion in U.S. mutual fund net asset value by asset type as of the end of 2008 is shown in Exhibit 4-19. A breakdown for the European mutual fund market is shown in Exhibit 4-20.

Stock and money market funds make up the largest segments of the U.S. mutual fund industry. Between 2007 and 2008, however, there was a dramatic shift in the relative proportion of net asset value in stock funds and money market funds. Although there was a significant increase in the total value of assets in money market funds (24 percent, or approximately US$700 billion), the biggest change was in the value of total assets of stock funds, which fell by 43 percent or approximately US$2.8 trillion. Close to 10 percent of this drop, or US$280 billion, was the result of redemptions exceeding new investments, with the remaining of the decline attributed to the dramatic fall in share prices during 2008.15 A similar drop in equity assets is evident in the European data.

5.2. Types of Mutual Funds

The following section introduces the major types of mutual funds differentiated by the asset type that they invest in: money market funds, bond mutual funds, stock mutual funds, and hybrid or balanced funds.

5.2.1. Money Market Funds

Although money market funds have been a substitute for bank savings accounts since the early 1980s, they are not insured in the same way as bank deposits. At the end of 2008, the total net asset value of U.S. money market funds was in excess of US$3.8 trillion, with a further €1 trillion in European money market funds. In the United States, there are two basic types of money market funds: taxable and tax-free. Taxable money market funds invest in high quality, short-term corporate debt and federal government debt. Tax-free money market funds invest in short-term state and local government debt. At the end of 2008 in the United States, there were approximately 540 taxable funds with about US$3.3 trillion in net asset value and approximately 250 tax-free money market funds with a total net asset value of about US$490 million. From an investor’s point of view, these funds are essentially cash holdings. As such, the presumption of investors is that the net asset value of a money market fund is always US$1.00 per share.

In September 2008 two large money market funds “broke the buck”; that is, the net asset value of the shares fell below US$1.00 per share. This drop in value caused investors to question the safety of money market funds and resulted in a massive outflow of funds from money market funds. This outflow continued until the U.S. Federal Reserve intervened to provide short-term insurance for some money market funds. This insurance, although similar to bank deposits, was limited in scope and time.

5.2.2. Bond Mutual Funds

A bond mutual fund is an investment fund consisting of a portfolio of individual bonds and, occasionally, preferred shares. The net asset value of the fund is the sum of the value of each bond in the portfolio divided by the number of shares. Investors in the mutual fund hold shares, which account for their pro-rata share or interest in the portfolio. The advantage is that an investor can invest in a bond fund for as little as US$100, which provides a stake in a diversified bond portfolio in which each individual bond may cost between US$10,000 and US$100,000. The major difference between a bond mutual fund and a money market fund is the maturity of the underlying assets. In a money market fund the maturity is as short as overnight and rarely longer than 90 days. A bond mutual fund, however, holds bonds with maturities as short as one year and as long as 30 years. Exhibit 4-21 illustrates the general categories of bond mutual funds.

EXHIBIT 4-21 Bond Mutual Funds

Type of Bond Mutual Fund	Securities Held
Global	Domestic and nondomestic government, corporate, and securitized debt
Government	Government bonds and other government-affiliated bonds
Corporate	Corporate debt
High yield	Below investment-grade corporate debt
Inflation protected	Inflation-protected government debt
National tax-free bonds	National tax-free bonds16 (e.g., U.S. municipal bonds)

An example of a typical bond mutual fund is the T. Rowe Price Corporate Income Fund. Exhibit 4-22 shows the asset composition, credit quality, and maturity diversification for this bond mutual fund.

EXHIBIT 4-22 Asset Composition of T. Rowe Price Corporate Income Fund As of 31 March 2009

Source: T. Rowe Price (www.troweprice.com).

5.2.3. Stock Mutual Funds

Historically, the largest types of mutual funds based on market value of assets under management are stock or equity funds. At the end of the third quarter of 2008, the worldwide investment in stock mutual funds totaled around US$8.6 trillion, with approximately US$4 trillion of that in U.S. stock mutual funds.

There are two types of stock mutual funds. The first is an actively managed fund in which the portfolio manager seeks outstanding performance through the selection of the appropriate stocks to be included in the portfolio. Passive management is followed by index funds that are very different from actively managed funds. Their goal is to match or track the performance of different indices. The first index fund was introduced in 1976 by the Vanguard Group. At the end of 2008, index funds held approximately 13 percent of the total net asset value of stock mutual funds.18

There are several major differences between actively managed funds and index funds. First, management fees for actively managed funds are higher than for index funds. The higher fees for actively managed funds reflect its goal to outperform an index, whereas the index fund simply aims to match the return on the index. Higher fees are required to pay for the research conducted to actively select securities. A second difference is that the level of trading in an actively managed fund is much higher than in an index fund, which has obvious tax implications. Mutual funds are required to distribute all income and capital gains realized in the portfolio, so the actively managed fund tends to have more opportunity to realize capital gains. This results in higher taxes relative to an index fund, which uses a buy-and-hold strategy. Consequently, there is less buying and selling in an index fund and less likelihood of realizing capital gains distributions.

5.2.4. Hybrid/Balanced Funds

Hybrid or balanced funds are mutual funds that invest in both bonds and shares. These types of funds represent a small fraction of the total investment in U.S. mutual funds but are more common in Europe. (See Exhibits 4-19 and 4-20.) These types of funds, however, are gaining popularity with the growth of life-cycle funds. These are funds that manage the asset mix based on a desired retirement date. For example, if an investor is 40 years old in 2008 and planned to retire at the age of 67, he could invest in a mutual fund with a target date of 2035 and the fund would manage the appropriate asset mix over the next 27 years. In 2008 it might be 90 percent invested in shares and 10 percent in bonds. As time passes, however, the fund would gradually change the mix of shares and bonds to reflect the appropriate mix given the time to retirement.

5.3. Other Investment Products

In addition to mutual funds, a number of pooled investment products are increasingly popular in meeting the individual needs of clients. The following section introduces these products: exchange-traded funds, separately managed accounts, hedge funds, and buyout and venture capital funds.

5.3.1. Exchange-Traded Funds19

Exchange-traded funds (ETFs) combine features of closed-end and open-end mutual funds. ETFs trade like closed-end mutual funds; however, like open-end funds, ETFs’ prices track net asset value due to an innovative redemption procedure. ETFs are created by fund sponsors who determine which securities will be included in the basket of securities. To obtain the basket, the fund sponsors contact an institutional investor who deposits the securities with the fund sponsor. In return, the institutional investor receives creation units that typically represent between 50,000 and 100,000 ETF shares. These shares can then be sold to the public by the institutional investor. The institutional investor can redeem the securities held in the ETF by returning the number of shares in the original creation unit. This process prevents meaningful premiums or discounts from net asset value. Closed-end mutual funds are predominantly actively managed stock or bond funds whereas ETFs are typically index funds. The first ETF was created in the United States in 1993 and in Europe in 1999. At the end of 2008, there were over 700 ETFs available in the United States with a total net asset value of over US$500 billion. A breakdown of the types of ETFs is shown in Exhibit 4-23.

EXHIBIT 4-23 Types of Exchange-Traded Funds (ETFs) January 2009

Source: Investment Company Institute, “Exchange-Traded Fund Assets, January 2009” (25 February 2009): http://ici.org/research/stats/etf/ci.etfs_01_09.print.

The major difference between an index mutual fund and an ETF is that an investor investing in an index mutual fund buys the fund shares directly from the fund and all investments are settled at the net asset value. In the case of an ETF, however, investors buy the shares from other investors just as if they were buying or selling shares of stock. This setup includes the opportunity to short the shares or even purchase the shares on margin. The price an investor pays is based on the prevailing price at the time the transaction was made. This price may or may not be equal to the net asset value at the time, but it represents the price at that time for a willing buyer and seller. In practice, the market price of the ETF is likely to be close to the net asset value of the underlying investments.

Other main differences between an index mutual fund and an index ETF are transaction costs, transaction price, treatment of dividends, and the minimum investment amount. Expenses are lower for ETFs but, unlike mutual funds, investors do incur brokerage costs. Also as noted previously, all purchases and redemptions in a mutual fund take place at the same price at the close of business. ETFs are constantly traded throughout the business day, and as such each purchase or sale takes place at the prevailing market price at that time. In the case of the ETF, dividends are paid out to the shareholders whereas index mutual funds usually reinvest the dividends. Hence, there is a direct cash flow from the ETF that is not there with the index mutual fund. Depending on the investor, this cash flow may or may not be desirable. Note that the tax implications are the same with either fund type. Finally, the minimum required investment in an ETF is usually smaller. Investors can purchase as little as one share in an ETF, which is usually not the case with an index mutual fund.

ETFs are often cited as having tax advantages over index mutual funds. The advantage is not related to the dividends but rather to capital gains. As long as there is no sale of assets in either fund, no taxable capital gains would be realized by investors. It is possible, however, that because of the flow of funds into and out of index mutual funds, these funds would have a greater likelihood of generating taxable capital gains for investors. Overall, it is not clear how much of an advantage there is or if there is any advantage at all.

5.3.2. Separately Managed Accounts

A fund management service for institutions or individual investors with substantial assets is the separately managed account (SMA), which is also commonly referred to as a “managed account,” “wrap account,” or “individually managed account.” An SMA is an investment portfolio managed exclusively for the benefit of an individual or institution. The account is managed by an individual investment professional to meet the specific needs of the client in relation to investment objectives, risk tolerance, and tax situation. In an SMA, the individual shares are held directly by the investor; and in return for annual fees, an individual can receive personalized investment advice.

The key difference between an SMA and a mutual fund is that the assets are owned directly by the individual. Therefore, unlike a mutual fund, the investor has control over which assets are bought and sold and the timing of the transactions. Moreover, in a mutual fund, there is no consideration given to the tax position of the individual asset. In an SMA, the transactions can take into account the specific tax needs of the investor. The main disadvantage of an SMA is that the required minimum investment is usually much higher than is the case with a mutual fund. Usually, the minimum investment is between US$100,000 and US$500,000.

Large institutions often use segregated accounts, which means their investments are held in an account on their behalf and managed by a portfolio manager or team. They can also use mutual funds. The decision on which approach to take often depends on the value of assets involved. Larger amounts of assets are more likely to be managed on a segregated basis.

5.3.3. Hedge Funds

The origin of hedge funds20 can be traced back as far as 1949 to a fund managed by A.W. Jones & Co. It offered a strategy of a noncorrelated offset to the “long-only” position typical of most portfolios. From this start emerged a whole new industry of hedge funds. Hedge fund strategies generally involve a significant amount of risk, driven in large measure by the liberal use of leverage and complexity. More recently, it has also involved the extensive use of derivatives.

A key difference between hedge funds and mutual funds is that the vast majority of hedge funds are exempt from many of the reporting requirements for the typical public investment company. In the United States, investment companies do not have to register with the U.S. Securities and Exchange Commission (SEC) if they have 100 or fewer investors [Section 3(c)1 of the Investment Company Act of 1940] or if the investor base is greater than 100 but less than 500 “qualified purchasers”21 [Section 3(c)7 of the Investment Company Act of 1940]. In order to qualify for the exemption, hedge funds cannot be offered for sale to the general public; they can only be sold via private placement. In addition, Regulation D of the Securities Act of 1933 requires that hedge funds be offered solely to “accredited investors.”22 The net effect of these regulations is that the hedge fund investor base is generally very different from that of the typical mutual fund.

From its start in 1955 to the end of 2008, the hedge fund industry has grown to over 9,200 hedge funds with approximately US$1.4 trillion in assets.23 Not all hedge funds are the same, however. Many different strategies are employed. A few examples24 include:

• Convertible arbitrage—Buying such securities as convertible bonds that can be converted into shares at a fixed price and simultaneously selling the stock short.
• Dedicated short bias—Taking more short positions than long positions.
• Emerging markets—Investing in companies in emerging markets by purchasing corporate or sovereign securities.
• Equity market neutral—Attempting to eliminate the overall market movement by going short overvalued securities and going long a nearly equal value of undervalued securities.
• Event driven—Attempting to take advantage of specific company events. Event-driven strategies take advantage of transaction announcements and other one-time events.
• Fixed-income arbitrage—Attempting to profit from arbitrage opportunities in interest-rate securities. When using a fixed-income arbitrage strategy, the investor assumes opposing positions in the market to take advantage of small price discrepancies while limiting interest rate risk.
• Global macro—Trying to capture shifts between global economies, usually using derivatives on currencies or interest rates.
• Long/short—Buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value. Unlike the equity market neutral strategy, this strategy attempts to profit from market movements, not just from identifying overvalued and undervalued equities.

The preceding list is not all-inclusive; there are many other strategies. Hedge funds are not readily available to all investors. They require a minimum investment that is typically US$250,000 for new funds and US$1 million or more for well-established funds. In addition, they usually have restricted liquidity that could be in the form of allowing only quarterly withdrawals or having a fixed-term commitment of up to five years. Management fees are not only a fixed percentage of the funds under management; managers also collect fees based on performance. A typical arrangement would include a 1 percent to 2 percent fee on assets under management and 20 percent of the outperformance as compared to a stated benchmark.

5.3.4. Buyout and Venture Capital Funds

Two areas that have grown considerably over the past 15 years have been buyout and venture capital funds. Both take equity positions but in different types of companies. An essential feature of both is that they are not passive investors, and as such, they play a very active role in the management of the company. Furthermore, the equity they hold is private rather than traded on public markets. In addition, neither intends to hold the equity for the long term; from the beginning, both plan for an exit strategy that will allow them to liquidate their positions. Both venture capital funds and private equity funds operate in a manner similar to hedge funds. A minimum investment is required, there is limited liquidity during some fixed time period, and management fees are based not only on funds under management but also on the performance of the fund.

6. SUMMARY

• In this chapter we have discussed how a portfolio approach to investing could be preferable to simply investing in individual securities.
• The problem with focusing on individual securities is that this approach may lead to the investor “putting all her eggs in one basket.”
• Portfolios provide important diversification benefits, allowing risk to be reduced without necessarily affecting or compromising return.
• We have outlined the differing investment needs of various types of individual and institutional investors. Institutional clients include defined benefit pension plans, endowments and foundations, banks, insurance companies, investment companies, and sovereign wealth funds.
• Understanding the needs of your client and creating an investment policy statement represent the first steps of the portfolio management process. Those steps are followed by security analysis, portfolio construction, monitoring, and performance measurement stages.
• We also discussed the different types of investment products that investors can use to create their portfolio. These range from mutual funds, to exchange-traded funds, to hedge funds, to private equity funds.

PROBLEMS25

1. Investors should use a portfolio approach to:

A. Reduce risk.

B. Monitor risk.

C. Eliminate risk.

2. Which of the following is the best reason for an investor to be concerned with the composition of a portfolio?

A. Risk reduction.

B. Downside risk protection.

C. Avoidance of investment disasters.

3. With respect to the formation of portfolios, which of the following statements is most accurate?

A. Portfolios affect risk less than returns.

B. Portfolios affect risk more than returns.

C. Portfolios affect risk and returns equally.

4. Which of the following institutions will on average have the greatest need for liquidity?

A. Banks.

B. Investment companies.

C. Non-life insurance companies.

5. Which of the following institutional investors will most likely have the longest time horizon?

A. Defined benefit plan.

B. University endowment.

C. Life insurance company.

6. A defined benefit plan with a large number of retirees is likely to have a high need for:

A. Income.

B. Liquidity.

C. Insurance.

7. Which of the following institutional investors is most likely to manage investments in mutual funds?

A. Insurance companies.

B. Investment companies.

C. University endowments.

8. With respect to the portfolio management process, the asset allocation is determined in the:

A. Planning step.

B. Feedback step.

C. Execution step.

9. The planning step of the portfolio management process is least likely to include an assessment of the client’s:

A. Securities.

B. Constraints.

C. Risk tolerance.

10. With respect to the portfolio management process, the rebalancing of a portfolio’s composition is most likely to occur in the:

A. Planning step.

B. Feedback step.

C. Execution step.

11. An analyst gathers the following information for the asset allocations of three portfolios:

Which of the portfolios is most likely appropriate for a client who has a high degree of risk tolerance?

A. Portfolio 1.

B. Portfolio 2.

C. Portfolio 3.

12. Which of the following investment products is most likely to trade at their net asset value per share?

A. Exchange-traded funds.

B. Open-end mutual funds.

C. Closed-end mutual funds.

13. Which of the following financial products is least likely to have a capital gain distribution?

A. Exchange-traded funds.

B. Open-end mutual funds.

C. Closed-end mutual funds.

14. Which of the following forms of pooled investments is subject to the least amount of regulation?

A. Hedge funds.

B. Exchange-traded funds.

C. Closed-end mutual funds.

15. Which of the following pooled investments is most likely characterized by a few large investments?

A. Hedge funds.

B. Buyout funds.

C. Venture capital funds.

1In the United States, 401(k) plans are employer-sponsored individual retirement savings plans. They allow individuals to save a portion of their current income and defer taxation until the time when the savings and earnings are withdrawn. In some cases, the sponsoring firm will also make matching contributions in the form of cash or shares. Individuals within certain limits have control of the invested funds and consequently can express their preferences as to which assets to invest in.

2Singletary (2001).

3This expression, which most likely originated in England in the 1700s, has a timeless sense of wisdom.

4A sample of five companies from a similar industry group was arbitrarily selected for illustration purposes.

5Mean quarterly returns are annualized by multiplying the quarterly mean by 4. Quarterly standard deviations are annualized by taking the quarterly standard deviation and multiplying it by 2.

6The S&P 500, Hang Seng, and Nikkei 500 are broad-based composite equity indices designed to measure the performance of equities in the United States, Hong Kong, and Japan. MSCI stands for Morgan Stanley Capital International. EAFE refers to developed markets in Europe, Australasia, and the Far East. AC indicates all countries, and EM is emerging markets. All index returns are in U.S. dollars.

7Markowitz (1952).

8Acharya and Dimson (2007).

9See www.insead.com/campaign/endowment/index.cfm.

10See www.wellcome.ac.uk/Investments/History-and-objectives/index.htm.

11See, for example, www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3518.

12SWF Institute (www.Swfinstitute.org/funds.php).

13Asset class definitions: Bonds—Debt instruments of corporations and governments as well as various types of mortgage- and asset-backed securities; Preferred and Common Shares—Investments in preferred and common equities; Mortgages—Mortgage loans secured by various types of commercial property as well as residential mortgage whole loan pools; Real Estate—Investments in real estate; Policy Loans—Loans by policyholders that are secured by insurance and annuity contracts; Partnerships—Investments in partnerships and limited liability companies; Cash—Cash, short-term investments, receivables for securities, and derivatives. Cash equivalents have short maturities (less than one year) or are highly liquid and able to be readily sold.

14Investment Company Institute (2009b).

15These figures were extracted from data in Investment Company Institute (2009a).

16In the United States, judicial rulings on federal powers of taxation have created a distinction between (federally) taxable and (federally) tax-exempt bonds and a parallel distinction for U.S. bond mutual funds.

17Bond rating is from Standard & Poor’s. AAA represents the highest credit quality. Bonds rated BBB and above are considered to be investment-grade bonds. Bonds rated below BBB are non-investment-grade bonds and are also known as high-yield or junk bonds.

18Mamudi (2009).

19For more-detailed information on ETFs, see Investment Company Institute (2007) or Gastineau (2002). An additional resource for information on ETFs can be found in the American Association of Individual Investors’ AAII Journal, which publishes an annual guide to ETFs in its October issue (see www.aaii.com/journal/index.cfm).

20For a more comprehensive discussion of hedge funds, refer to Sihler (2004). Most of the discussion here is drawn from that document.

21A “qualified purchaser” is an individual with over US$5 million in investment assets.

22An “accredited individual” investor must have a minimum net worth of US$1 million or a minimum individual income of US$200,000 in each of the two most recent years with the expectation of having the same income in the current year. An accredited institution must have a minimum of US$5 million in invested assets.

23Both the number of hedge funds and the value of assets under management fell dramatically in the second half of 2008. According to Hedge Fund Research, Inc., during 2008 the total number of funds fell by 8 percent and the value of assets under management fell from approximately US$1.9 trillion to US$1.4 trillion at the end of 2008.

24In the examples, “long” refers to owning the security and “selling short” refers to a strategy of borrowing shares and converting them to cash with the intention of repaying the shares at a later date by buying them back at a lower price. Long positions have a positive return when the price of the security increases, and short positions have a positive return when the price of the security falls.

25These practice questions were developed by Stephen P. Huffman, CFA (University of Wisconsin, Oshkosh).