Summary

THE CANADIAN SECURITIES INSTITUTE

The Canadian Securities Institute (CSI) has been providing financial education for 50 years, training over one million professionals globally. CSI offers programs in securities, banking, insurance, and wealth management, partnering with regulators to meet market needs. Their credentials enable professionals to advance their careers with on-demand courses.

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PORTFOLIO MANAGEMENT TECHNIQUES

The section provides contact information for the Canadian Securities Institute, along with important notices and copyright details.

• CSI has offices in Toronto and Montreal, with telephone numbers and website provided.

• The publication is for registered students only and should not be lent, borrowed, or resold.

• References to third party materials are included for convenience, with no endorsement implied.

• The publication is intended for information and educational use, not as financial or professional advice.

• Copyright for the publication is held by the Canadian Securities Institute, with strict reproduction guidelines in place.

Content Overview

The document covers various aspects of portfolio management including ethics, institutional investors, equity and fixed income portfolios, derivatives, alternative investments, and client reporting. It also discusses bond portfolio construction techniques, high yield bonds, and ETFs.

Table of Contents

This section provides an in-depth look at portfolio management, ethics, fixed income portfolios, derivatives, and alternative investments.

• Registration categories under NI 31-103 include dealer, advisor, and individual categories.

• Investment industry regulations cover CIRO-managed account requirements and FINTRAC guidelines.

• Ethics in portfolio management involve understanding values, ethical dilemmas, and a code of ethics.

• Trust and fiduciary duty are essential components of ethical portfolio management.

• Corporate governance is crucial for effective portfolio management practices.

• Managing fixed income portfolios involves trading operations, management styles, and box trades.

• The permitted uses of derivatives by mutual funds are outlined, including hedging and non-hedging purposes.

• New investment product development process involves identifying market opportunities, assessing legal restrictions, and launching the product.

Portfolio Management: Overview

The text discusses the role of a portfolio manager, registration categories under NI 31-103, investment industry regulations, managed accounts within a CIRO Dealer Member, and best practices in the investment management industry. It also covers the regulatory environment in Canada, compliance requirements of FINTRAC, and various investment practices regulated by CSA. The text outlines key terms, including dealers, FINTRAC, KYC rule, and PIPEDA.

INTRODUCTION

The evolution of investing and portfolio management in the financial services industry.

• In the 1930s, Graham and Dodd introduced the concept of valuing securities based on attractiveness.

• Modern Portfolio Theory (MPT) was developed in the 1950s by Harry Markowitz at the University of Chicago.

• Shift from defined benefit to defined contribution pension plans for retirement planning.

• Increasing importance of portfolio management due to longer life expectancy and individual investment responsibility.

WHAT IS A PORTFOLIO MANAGER?

This section discusses the role, regulations, and best practices for portfolio managers.

• Portfolio managers advise clients on investments based on individual circumstances and objectives.

• National Instrument 31-103 outlines the qualifications required for portfolio managers.

• Different registration categories exist for dealers, advisors, and individuals in the investment industry.

• CIRO sets proficiency requirements for portfolio managers and associate portfolio managers.

• Best practices include ensuring best execution, maintaining proper records, and managing conflicts of interest.

• Soft dollar arrangements and compliance with FINTRAC are important considerations for portfolio managers.

• Managed accounts offer personalized, cost-effective services to high-net-worth clients.

• Benchmark metrics are used to evaluate the performance of managed accounts.

SUMMARY

This section covers portfolio management, registration categories, regulatory environment, CIRO-managed account rules, CSA investment practices, FINTRAC compliance, and industry best practices.

• Portfolio managers advise clients on investments based on individual circumstances and objectives.

• Canada has various dealer and advisor registration categories under provincial regulators.

• The CSA regulates activities like high closing, late trading, and client privacy requirements.

• FINTRAC requires reporting of suspicious transactions, large cash transactions, electronic funds transfers, and terrorist property.

• Portfolio managers must verify client identity and maintain signed account applications.

• Best practices in the industry include guidelines on best execution, record-keeping, conflicts of interest, and fair dealing.

• Firms must adhere to standards for trading errors, personal trading, confidentiality, and trading of non-public information.

• Compliance with FINTRAC and CSA regulations is essential for portfolio managers and firms.

Ethics and Portfolio Management

Ethics in investment management industry is crucial for trust and fiduciary duty. A value system influences behavior, with best practices in a firm's code of ethics.

INTRODUCTION

This section discusses the crucial role of ethics, trust, and fiduciary duty in investment management.

• Investment management relies on trust, ethics, and fiduciary duty for success.

• Advisors are expected to prioritize client interests and make quick decisions based on ethical principles.

• Compliance departments and supervisors provide guidance for discretionary portfolio managers.

• Best practices in portfolio management involve a combination of intellectual and moral excellence.

ETHICS

This section discusses the importance of ethics in the financial services industry, including the definition of ethics, values, and ethical dilemmas faced by professionals. It also covers the impact of ethical behavior on clients, registrants, and the industry as a whole.

• Ethics in the financial services industry provide a foundation for rules and regulations.

• Good ethics are essential for long-term success in business.

• Values such as honesty, integrity, and trustworthiness guide individual and corporate behavior.

• Ethical dilemmas can arise when different values conflict with each other.

• Resolving ethical dilemmas requires careful consideration and avoiding rationalizations.

• Case studies highlight ethical challenges faced by professionals in the industry.

• Ethical behavior is crucial for maintaining the reputation and integrity of the industry.

• Upholding ethical standards is essential for building trust with clients and stakeholders.

CODE OF ETHICS

This section emphasizes the significance of having a code of ethics in institutional investment management firms. It discusses the strengths and weaknesses of a code of ethics, the elements necessary for its effectiveness, and the importance of compliance and adherence.

• A code of ethics is crucial for reinforcing ethical behavior in discretionary portfolio managers.

• It helps in ensuring fair treatment of clients, proper functioning of investment management firms, and regulatory compliance.

• The strengths of a code of ethics include providing guidance on appropriate behavior and fostering a social contract in the workplace.

• However, weaknesses include the risk of complacency and focusing only on resolving conflicts between right and wrong.

• For a code of ethics to be effective, senior management support, employee participation, training, and periodic review are necessary.

• Compliance and adherence to a firm's code of ethics should start from an employee's first day on the job.

• Good business practice involves distributing the code of ethics annually and having employees reaffirm their commitment to it.

• An example is given regarding personal investment activities of institutional investment manager's staff, emphasizing the importance of written guidelines and prior approval processes.

TRUST AND FIDUCIARY DUTY

This section discusses trust in client relationships, fiduciary duty, and ethical considerations in investment management.

• Trust is built on specialized knowledge, industry regulation, and client interests.

• A portfolio manager must prioritize competence and integrity to establish trust with clients.

• Fiduciary duty requires acting in the client's best interest without personal gain.

• Discretionary portfolio managers are always considered fiduciaries, held to the highest standard of care.

• Institutional investment funds and corporate pension plans also involve fiduciary duties.

• Fiduciaries must act prudently, follow fund documents, and diversify investments.

• A case study highlights the importance of ethical decision-making in offering investment products.

• Advisors must prioritize client well-being and report any concerns to superiors.

SUMMARY

This section discusses ethics, value systems, ethical dilemmas, and best practices in the investment management industry.

• Ethics are crucial in guiding behavior in the financial services industry where regulations may not apply.

• A unified value system is essential for portfolio managers to make ethical decisions.

• Ethical dilemmas arise when conflicting values are at play, such as truth versus loyalty.

• Strengths of a code of ethics include providing a social contract and supporting responsibilities.

• Best practices for firms include distributing the code of ethics annually and having written personal trading guidelines.

APPENDIX A

CIRO's IDPC Rule 1402 outlines expectations for regulated persons, emphasizing high ethical standards, fair business conduct, and compliance with legal obligations. Any conduct that is negligent, fails to comply with regulations, or diminishes investor confidence may be considered a violation.

APPENDIX B

This section outlines the ethical responsibilities of CIM® designates towards legal compliance, clients, the profession, and their employers.

• CIM® designates must comply with legal and regulatory principles governing the financial services industry.

• They must act with dignity, integrity, and professional competence when dealing with clients and colleagues.

• CIM® designates are required to maintain knowledge of and comply with all applicable laws and regulations.

• They must treat each client with respect and put the client's interests ahead of their own.

• CIM® designates must exercise due diligence in making recommendations for financial products.

• They are obligated to preserve the confidentiality of information communicated by clients, prospects, and employers.

• CIM® designates must not engage in any professional conduct involving dishonesty, fraud, or misrepresentation.

• They have responsibilities towards their employers, including placing their interests ahead of their own and disclosing any matters that could interfere with their duty.

INTRODUCTION

Overview of financial intermediaries in Canada and their role in pooling individual investors' capital to lend or invest on more favorable terms.

• Financial intermediaries in Canada, such as banks and mutual funds, pool individual investors' capital to meet the massive funding needs of governments and corporations.

• These intermediaries offer investment products and services that are not otherwise available to individual investors due to the small amount of funds typically available to them.

• The success of financial intermediaries in Canada is evident by the size of the largest financial institutions, which rank among the top 10 corporations in the country.

• The financial sector in Canada has been a significant source of employment and economic growth, with various firms and organizations playing a key role in the economy.

FINANCIAL INTERMEDIATION

The section discusses the growth and changes in financial intermediaries over the past 50 years.

• Factors like demographic influences and innovation led to the growth of various financial intermediaries after the mid-1960s.

• There was a shift in market share from banks and life insurance companies to mutual funds, pension plans, and endowments.

• Financial intermediaries, rather than individual investors, became more active in the market, especially in using financial derivatives.

• Regulatory concerns and the need for risk management strategies drove financial intermediaries to use derivatives extensively.

• Institutional investors, including pension plans, mutual funds, and insurance companies, play a significant role in the financial market.

• Traditional categories of institutional investors are evolving, with increasing integration and competition among them.

• The industry has seen an explosion in the size, number, and variety of financial intermediaries due to various factors driving growth and change.

DID YOU KNOW?

Overview of Collective Investment Vehicles and Pension Plans

• Pooled investment vehicles like mutual funds and ETFs aim to lower costs and achieve better diversification for investors.

• Pension plans, managed internally or externally, provide retirement benefits through contributions from sponsors and beneficiaries.

• Third-party investment managers are commonly used by pension plans for specialized expertise in areas like hedge funds and private equity.

• Mutual funds have become the primary investment vehicle for individual investors due to their attractive risk-return profile.

DIVE DEEPER

This section discusses pension fund management, investment consultants, fund rating agencies, and market index providers.

• Defined benefit (DB) and defined contribution (DC) pension plans differ in investment risk distribution.

• DB plans guarantee pension payments, while DC plans rely on investment performance.

• Shift from DB to DC plans due to mobile workforce and financial statement impact.

• Life insurance companies offer products tailored to pension plans' needs.

• Mutual funds have grown due to individual investors' preference and diversification.

• Endowment funds manage portfolios to generate income for beneficiary organizations.

• Corporate treasuries manage financial assets and investment management activities.

• Investment consultants advise institutional asset holders on external investment managers.

GOVERNANCE

This section discusses the oversight and regulation of institutional investment managers in Canada by key regulators.

• Two main regulators in Canada are the Office of the Superintendent of Financial Institutions and provincial/territorial securities regulators.

• The OSFI supervises federally regulated financial institutions and pension plans to ensure sound financial condition.

• Provincial and territorial securities regulators enforce regulations for securities markets and participants.

• Institutional investment funds follow established governance standards and practices.

• Governance structure typically includes a board of trustees, investment committee, investment consultant, and investment manager.

• The board of trustees is responsible for approving the fund's investment policy statement.

• The investment committee creates and implements the investment management framework.

• Investment managers are appointed to manage fund assets within the guidelines set by the fund's IPS.

SUMMARY

This section covers financial intermediation, institutional investors, industry participants, principal-agent relationships, regulatory environment, and governance of investment funds.

• Financial intermediation involves the movement of funds between suppliers and users of capital.

• Institutional investors include pension funds, insurance companies, mutual funds, endowments/trusts, and corporate treasuries.

• Investment/pension consultants, fund rating agencies, and market index providers aid in selecting financial intermediaries.

• Investment management involves principal-agent relationships, varying for individual and institutional investors.

• The regulatory environment in Canada is overseen by OSFI and provincial securities regulators.

• Governance of investment funds involves the board of trustees, investment committee, investment consultant, and investment manager.

The Investment Management Firm

The text covers topics such as ownership structures, investor types, investment product structures, fees, industry challenges, and corporate governance in institutional investment management. Major types of investors include pension funds (60%), insurance companies (20%), and endowments (10%). Challenges faced include regulatory changes and market volatility.

INTRODUCTION

This section discusses institutional investment managers, their target investors, marketing strategies, competition, and investment mandates.

• Institutional investment managers focus on managing investments for institutional investors like pension plans and endowments.

• These firms do not target retail investors and have minimal advertising budgets compared to mutual fund companies.

• Some institutional investment managers offer Canadian balanced funds as their largest mandate.

• There is a growing interest in global investment mandates among institutional investors.

• The chapter covers ownership structures, regulations, product structures, roles of investment managers, and industry challenges.

OWNERSHIP AND COMPENSATION STRUCTURES

This section discusses the ownership structures, compensation, and legal requirements for investment management firms in Canada. It also covers the benefits of corporate ownership and the types of ownership structures commonly found in the industry.

• Investment management firms in Canada are structured as corporations to receive registration from securities regulators.

• Privately owned firms are usually structured as partnerships, with active staff members holding shares.

• Some medium to large-sized firms may allow a minority investment by an institutional investor.

• Compensation for institutional investment managers includes base salary, cash bonuses, shares or options, and profit sharing.

• Cash bonuses for portfolio managers range from 25% to 200% of their base salary.

• Profit sharing is based on a percentage of the firm's profits and is distributed to selected portfolio management staff.

• Institutional investment managers may receive equity options in a publicly traded parent company.

• Publicly owned financial institutions consolidate their investment management operations within wholly owned subsidiaries.

REGULATIONS AND LICENSING

The section discusses the regulatory supervision of Canadian institutional investment management industry by provincial and territorial securities commissions, including the requirements for securities registrations and licences.

• Institutional investment management firms must hold securities registrations in each province where targeted investors reside.

• Larger firms may have registrations in almost every province, while smaller firms may be registered in only one or two provinces.

• The firm itself must hold a securities registration as a legal entity, while individual portfolio managers must also be registered.

• Insurance coverage is required for potential claims and litigation against the investment management firm.

ORGANIZATIONAL STRUCTURE

Overview of organizational structure and roles in investment management firms.

• Good organizational structure design is crucial for institutional investment management firms.

• A typical organizational structure includes front, middle, and back offices.

• The separation of duties principle is important to prevent employee self-dealing.

• The ultimate designated person (UDP) and chief compliance officer (CCO) are critical regulatory positions.

• UDP is responsible for the firm's conduct, while CCO ensures compliance standards are met.

• UDP and CCO must be registered in each exempt market dealer.

• Different individuals should ideally hold the UDP and CCO positions.

• Institutional investors verify information from third-party service providers for accuracy.

INVESTOR TYPES

This section discusses different types of investors, their communication requirements, and servicing expectations in investment management firms.

• Institutional investment management firms need to cater to non-exempt and exempt investors, each with different requirements.

• Non-exempt investors, like mutual fund investors, require securities to be sold via a prospectus.

• Exempt investors can participate in the exempt market under certain conditions.

• Small institutional firms match investors with portfolio managers for personalized service.

• Medium to large firms have dedicated client service staff for investor support.

• Mutual fund investors receive limited communication directly from portfolio managers.

• Institutional investors expect detailed portfolio performance reviews and quarterly reports.

• High-net-worth clients meet with investment managers semi-annually or annually for personalized service.

SERVICE CHANNELS

This section discusses different channels used by institutional investment management firms in Canada, including pooled funds, segregated accounts, limited partnerships, and sub-advisory capacity. It also explains the importance of written investment management agreements and the key features of each product structure.

• Pooled funds are the largest product structure used by Canadian institutional investment managers, with trust companies, investment management firms, and insurance companies offering them.

• Institutional investors and high-net-worth individuals prefer segregated accounts for personalized investment portfolios and lower administrative fees.

• Limited partnerships (LPs) are commonly offered to both institutional and individual investors, providing features like tax-loss selling and limited liability.

• LPs have been used for over 100 years in the institutional and high-net-worth investor markets, but constitute a small proportion of product structures.

• Mutual funds in Canada are mostly structured as open-ended unit trusts, with a few structured as corporations.

• Portfolio managers in mutual funds deliver specific investment management services and are not responsible for other duties like marketing or performance measurement.

• Institutional investment managers prefer limiting the number of pooled funds they offer for administrative ease.

• A written investment management agreement is a best practice between institutional investment management firms and investors in Canada.

INVESTMENT MANDATES

This section discusses the impact of investment mandates on firm structure and operations, covering topics such as domestic and global investing, specialty funds, responsible investment, and alternative investments.

• Canadian institutional firms focus on domestic investment mandates like money market, fixed income, equities, and balanced funds.

• Balanced fund mandates are popular, managed by separate departments with asset mix committees determining allocations.

• Specialty and sector-focused mandates are less common, managed by mutual fund companies or specialized firms.

• Responsible investment incorporates ESG factors and various ethical investing approaches.

• Investment managers categorize strategies into growth, value, GARP, momentum, and technically based styles.

• Passive investment products are growing in popularity due to lower costs and tracking errors.

• Alternative investments like hedge funds require additional skills and operational changes.

• Global investing involves significant structural and operational adjustments, often requiring physical presence in foreign markets.

ROLES AND RESPONSIBILITIES OF INSTITUTIONAL INVESTMENT MANAGERS

This section discusses the roles and responsibilities of various entities involved in managing Canadian investment funds.

• Individuals applying for a portfolio manager licence must meet specific education and investment experience qualifications.

• Investment funds must be managed by a registered portfolio manager, who is ultimately responsible for managing the fund and its assets.

• Investment advisors can hire sub-advisors to assist in managing a fund, but they are responsible for the actions of the sub-advisors.

• A detailed due diligence review of potential sub-advisors is required before entering into an agreement.

• The fund manager, principal distributor, trustee, custodian, registrar, auditor, and independent review committee play key roles in managing a mutual fund.

• The fund manager is responsible for the day-to-day administration of a mutual fund's operations.

• The principal distributor handles marketing and distribution of the mutual fund.

• The trustee holds the title to the mutual fund's assets on behalf of its unitholders.

INVESTMENT MANAGEMENT FEES

This section discusses the various fees and expenses associated with Canadian mutual funds, including fund manager fees, investment management fees, and global investment mandates. It also highlights the importance of business management skills in the institutional investment management industry.

• Investors in Canadian mutual funds typically pay fees ranging from 2% to 2.5% per year, with investment management fees making up only 20% to 30% of the total fees.

• Investment management fees vary by mandate, with money market mandates having the lowest fees and small-cap equity mandates having the highest.

• Global investment mandates have higher fees compared to domestic markets, with large-cap global equity funds starting at 100 basis points per year.

• Hedge funds charge asset-based fees of 1.5% to 2% and performance fees of 20% of the increase in a fund's value.

• Institutional investment managers negotiate tiered fees that decline as fund size increases, sharing economies of scale with investors.

• Short selling is limited in conventional mutual funds, with restrictions on short sales not exceeding 20% of net asset value.

• Poor business management skills can lead to audit failures, operational deficiencies, and distractions from portfolio performance.

• Operational weaknesses can increase insurance premiums and lead to civil litigation from investors for financial losses.

INDUSTRY CHALLENGES

This section discusses challenges and strategies in institutional investment management industry.

• Institutional investment managers face challenges like investment performance, compliance improvements, and global competition.

• Factors contributing to industry growth include demographics, economic growth, and technological advances.

• Firms can invest in internal distribution teams, expand distribution networks, or pursue both options.

• Compliance improvements lead to benefits like fewer regulatory issues and increased client satisfaction.

• Global competition is increasing due to improvements in communications and technology.

• Foreign global competitors are hiring Canadian managers for their Canadian operations.

• Downward pressure on investment management fees is likely to continue.

• Established firms rely on long-term portfolio performance and client service to maintain fee structure.

HUMAN RESOURCES

The text discusses the key skills, competition, and compensation in the institutional investment management industry.

• Fixed capital requirements in the industry are very low.

• Success in generating competitive rates of return and accumulating assets is quantifiable and easily communicated.

• "Star manager" approach is adopted by some firms for marketing, but it poses a risk if key individuals leave.

• Compensation schemes vary, with equity ownership being a key factor in attracting and retaining top talent.

GROWTH OF PASSIVE INVESTMENT MANDATES

The text discusses the rise of passive investing, threats to the industry, good corporate governance practices, and potential benefits.

• Passive investing has grown significantly since the mid-1990s, diverting assets from active management.

• Investment management fees for passive mandates are lower than active strategies.

• Exchange-traded index funds (ETFs) are gaining popularity among investors.

• Good corporate governance practices are crucial for institutional investment firms.

• Firms must instill a culture of fiduciary duty and compliance with regulations.

• Real-time monitoring of policies and procedures is essential for compliance.

• Organizational design should facilitate independence in compliance, audit, and legal functions.

• Benefits of good corporate governance include attracting institutional investors, reducing business risk, and enhancing operational efficiency.

SUMMARY

This section covers ownership structures, organizational setups, investor types, product structures, investment mandates, mutual fund management, fee collection, industry challenges, and governance in investment management firms.

• Investment management firms in Canada are structured as corporations to receive registration from securities regulators.

• Private ownership can be 100% employee-owned or employee majority-owned with a passive external owner.

• Institutional investment management firms organize departments into front, middle, and back offices.

• Major types of investors include non-exempt (small retail) and exempt investors (institutional and individual).

• Institutional investment managers offer services through pooled funds, segregated accounts, limited partnerships, and sub-advisory capacity.

• Investment mandates like alternative investments and global mandates can impact a firm's structure and operations.

• Mutual fund management involves roles like fund manager, principal distributor, trustee, custodian, registrar, auditor, independent review committee, and portfolio advisor.

• Investment managers collect fees from mutual fund unitholders and hedge funds charge investment management and performance fees.

• Challenges in the industry include investment performance, compliance requirements, competition, staff retention, and growth of passive strategies.

• Good governance is crucial for executing fiduciary duties and ensuring regulatory compliance in investment management firms.

The Front, Middle, and Back Offices

The text provides an overview of the front office operations in an institutional investment management firm, covering key areas such as information flow, client acquisition and retention, risk control, and reasons for contract termination. It also delves into the organizational structure and roles of the middle and back office functions.

INTRODUCTION

The chapter covers front, middle, and back office functions in an institutional investment firm. Information flows, best practices, client acquisition, and retention are discussed. Key interfaces, information flow, and best practices are explained for each area. The chapter concludes with back office best practices.

AN OVERVIEW OF THE FRONT OFFICE

In a modern institutional investment management firm, the front office is responsible for portfolio management, trade execution, sales and marketing, and client service. Portfolio management and trade execution are often handled by the same individual, while sales and marketing are combined with client service. As firms grow, these functions may be separated into four sub-groups.

THE FOUR AREAS OF THE FRONT OFFICE

This section discusses the organizational structure and functions of institutional investment management firms.

• The chief investment officer oversees portfolio management activities and chairs the asset mix committee.

• Head of equities and fixed income manage respective portfolios and supervise portfolio managers.

• Portfolio managers make day-to-day investment decisions within set guidelines.

• Traders execute security trades efficiently and effectively, working closely with portfolio managers.

• Sales and marketing activities are crucial for attracting investors and growing assets.

• Client service is essential for maintaining investor confidence and retention.

• Client service and sales functions may be performed by the same individuals in smaller firms.

• Effective client service can help firms retain investors even during periods of deteriorating portfolio performance.

INFORMATION FLOW AMONG FRONT OFFICE STAFF

This section discusses the flow of information among front office staff members and external contacts.

• Portfolio managers are in constant contact with other front office staff members and trading staff throughout the day.

• Traders primarily interface with portfolio managers when establishing a trading program.

• Traders have ongoing relationships with as many as 20 to 30 domestic and U.S. investment dealers.

• Sales and marketing staff rely on input from portfolio management staff for updating marketing materials.

• Client service staff work closely with portfolio managers to communicate portfolio strategy and results to investors.

• Institutional investors receive monthly reports containing detailed portfolio holdings and security transactions.

• Quarterly reports to investors include return data, holdings data, attribution analysis, and market commentary.

• Portfolio managers include all portfolio return information on a yearly, quarterly, and monthly basis since inception of the relationship with the investor.

FRONT OFFICE BEST PRACTICES

This section discusses organizational design, fund performance measurement, personal trading policies, and investment management agreements in the institutional investment industry.

• Good organizational design in institutional investment firms involves the separation of duties principle.

• Accurate calculation of investment fund performance is crucial for reporting to investors and third parties.

• Middle office staff should be responsible for calculating periodic rates of return to avoid conflicts of interest.

• Security transaction confirmations should be signed by two approved individuals in the portfolio management group.

• A security transaction signing authority matrix should be developed and approved by senior management.

• Firms should have a clearly written policy regarding personal investing activities of staff.

• Pre-trade personal trading clearance policy involves obtaining permission from the compliance department.

• Investment management agreements govern the relationship between institutional investment managers and their clients.

GETTING CLIENTS

This section discusses sales and marketing strategies for institutional clients, including direct contact and the use of pension consultants. It also covers the process of creating sales and marketing literature, determining approaches, and preparing presentations for potential investors.

• Institutional investors can be dissatisfied with current managers, leading to opportunities for new asset management.

• Sales and marketing materials focus on owners/portfolio managers, investment mandates, strategy, and performance track record.

• Two main sales and marketing approaches for institutional investors are direct contact and use of pension consultants.

• Pension consultants play a key role in hiring new investment managers for institutional clients.

• Institutional investment management firms must have at least a three-year track record to be considered by potential investors.

• Once awarded an investment mandate, the firm must go through the contracting process.

• Individual investors must qualify as "exempt" investors and have a minimum initial investment threshold.

• Firms may offer individual investors managed accounts or units of pooled fund products, with regular client service meetings based on investment amount.

LOSING CLIENTS

This section discusses reasons for contract terminations, performance evaluation, and client service in investment management.

• Contract terminations are mainly due to weak investment performance relative to peers or low-quality client service.

• Institutional investors prefer firms with at least three years of experience for more confidence in hiring decisions.

• Performance reviews are done quarterly by investment committees, comparing results with peers.

• Firms slipping into the third or fourth quartile for consecutive quarters may be put on notice.

• Absolute underperformance compared to peers can lead to termination, depending on the spread.

• Poor client service can also lead to termination, especially if accompanied by poor investment results.

• Notice periods for improvement typically range from two quarters to one year.

• Termination is immediate if a firm fails to adhere to investment guidelines and restrictions.

OVERVIEW OF THE MIDDLE OFFICE

A modern institutional investment management firm's middle office consists of four main functions: compliance, legal, auditing, and accounting. The functional heads of each area report to the firm's president, with the exception of the chief compliance officer in some cases. Small-to medium-sized firms may consolidate or outsource some functions, except for compliance which must be staffed internally. The back office handles trade settlements.

THE MIDDLE OFFICE

This section discusses the roles and responsibilities of compliance, legal, auditing, and accounting functions in an investment management firm.

• Compliance function ensures firm's adherence to regulations and best practices, with a focus on licensing and regulatory reporting.

• Legal function supports firm in legal matters, including contracts and agreements.

• Auditing function verifies firm's operations comply with established procedures, with external auditors required for certain reports.

• Accounting function provides financial accounting services for the firm and fund accounting for managed funds.

• Compliance department acts as a liaison with securities regulators.

• Legal function provides support during operational changes and new ventures.

• Auditing function interacts with all aspects of the firm during audit cycles.

• Accounting function interfaces with various departments for data confirmation.

THE BACK OFFICE

The section discusses the trade settlement function, factors influencing security transactions, and best practices in a firm's back office.

• The trade settlement function in a firm's back office ensures efficient and effective settlement of security transactions.

• Factors influencing security transactions include the number of mandates, type of mandate, geographic aspects, and trading philosophy.

• Portfolio turnover ratio can range from 0.25 to 4, with most funds falling between 0.75 to 1.25.

• Internal interfaces in the back office include portfolio managers, trading staff, and fund accounting function.

• Key best practices in a firm's back office include timely settlement of trades and effective communication between internal interfaces.

SUMMARY

This section covers the organizational structure, roles, and responsibilities of front, middle, and back office functions in an institutional investment management firm.

• Front office responsibilities include portfolio management, trade execution, sales, and client service.

• Key roles in portfolio management include CIO, heads of equities and fixed income, portfolio managers, and traders.

• Sales and marketing strategy involves creating literature, determining approach, and preparing presentations.

• Client service is crucial for retaining and growing assets, demonstrating commitment, and reducing manager's time away from office.

• Best practices for risk control and securities trading include dual signatures and compliance tests.

• Contract terminations are often due to weak investment performance or low-quality client service.

• Middle office functions include compliance, legal, audit, and accounting to ensure regulatory and legal compliance.

Managing Equity Portfolios

The text discusses various approaches to equity portfolio management, including bottom-up and top-down strategies, as well as value-oriented and growth-oriented investing. It also covers passive and active styles of management, risk budgeting, the use of derivatives, taxation considerations, and the role of exchange-traded funds (ETFs) in portfolio management. The text provides a comprehensive overview of key concepts and techniques in equity portfolio management.

INTRODUCTION

This section discusses the importance of asset diversification in portfolio construction and management.

• Asset diversification reduces risk in a portfolio for a given level of expected return.

• Harry M. Markowitz's work in 1952 laid the foundation for modern portfolio theory.

• Portfolio managers combine many assets to eliminate diversifiable risk and achieve desired risk-return structure.

• Institutional investors are adopting hedge fund strategies to increase returns.

BOTTOM-UP AND TOP-DOWN APPROACHES

The section discusses value-oriented and growth-oriented bottom-up approaches in portfolio management.

• Portfolio managers use either top-down or bottom-up approach based on market efficiency assumptions.

• Value-oriented approach seeks undervalued securities with low P/E ratios and discounts to book value.

• Warren Buffett is an example of a value-oriented manager who holds investments for a long time.

• Benjamin Graham's net current asset value strategy involves selecting stocks selling for 66.67% or less of their net current asset value.

• Growth-oriented approach focuses on earnings growth rates and has higher portfolio turnover.

• Top-down approach involves macroeconomic analysis to select sectors expected to outperform.

• Portfolio managers using top-down approach may display active management styles like sector rotation or market timing.

• Both approaches require superior skills to identify undervalued securities or sectors with growth potential.

PORTFOLIO MANAGEMENT STYLES

This section discusses equity portfolio management styles, including passive and active management, index fund construction, fundamental indexing, closet indexing, enhanced indexing, sector rotation, timing, value vs. growth investing, capitalization, portable alpha strategy, derivatives strategy, and prime brokerage structure.

• Equity portfolio managers specialize in active and passive management styles.

• Index funds can be constructed through replication, tracking, or fundamental indexing.

• Fundamental indexing uses metrics like cash flow and book value to weight stocks.

• Closet indexing involves mimicking a benchmark to avoid underperforming.

• Enhanced indexing allows for excess returns with some active risk.

• Sector rotation and timing strategies aim to capitalize on market movements.

• Value and growth investing focus on different types of stocks.

• Portable alpha strategies separate alpha and beta returns for enhanced performance.

THE USE OF DERIVATIVES IN EQUITY PORTFOLIO MANAGEMENT

This section discusses the use of equity index derivatives for risk reduction and portfolio adjustments.

• Diversification can reduce unsystematic risk to zero, but systematic risk remains.

• Equity index futures can be used for short and long hedging to manage risk.

• Short hedges involve selling futures to protect against market declines.

• Long hedges involve buying futures to add positions to a portfolio.

• The hedge ratio is calculated using the portfolio's beta and dollar value.

• Stock index futures allow easy and inexpensive changes to a portfolio's asset mix.

• Equity swaps offer various risk management products based on equity cash flows.

• Synthetic equity positions and transforming equity returns into other assets are possible with equity swaps.

TAX CONSIDERATIONS

The tax treatment of income in a portfolio determines the most suitable type and management style for investors based on their marginal tax rate, investment horizon, and income needs. Non-taxable foundations and registered plans allow income streams to compound tax-free. Active management styles can add significant value to a portfolio when gains are tax-exempt.

THE USE OF EXCHANGE-TRADED FUNDS IN EQUITY PORTFOLIO MANAGEMENT

This section discusses the use of ETFs by portfolio managers, covering transparency, targeted exposure, tax efficiency, lower costs, liquidity management, transition management, core and satellite strategies, simplified exposure, rebalancing, tactical asset allocation, model consistency, tax-loss selling, hedging, and fund company considerations.

• ETFs were first introduced for institutional markets before becoming popular retail products.

• Four industry trends driving ETF growth include fee-based business, advisor portfolio managers, demand for transparency, and broad choices.

• ETFs offer transparency through daily disclosure of holdings and rules governing them.

• ETFs provide targeted exposure with diversification, tax efficiency, and lower costs compared to mutual funds.

• ETFs offer liquidity, allowing quick implementation of investment decisions with minimal transactions.

• ETFs are used for transition management, core and satellite strategies, and simplified exposure to various asset classes.

• ETFs enable rebalancing and tactical asset allocation, providing consistency in applying investment models.

• ETFs can be used for tax-loss selling, hedging, and require due diligence on fund company management and servicing.

SUMMARY

This section covers bottom-up and top-down approaches, value vs growth investing, passive vs active management, risk budgeting, derivatives, taxation, and ETFs.

• Bottom-up approach involves selecting individual securities, while top-down approach starts with economic analysis.

• Value-oriented investing focuses on undervalued securities, while growth-oriented looks for superior earnings growth.

• Passive management assumes efficient markets and uses techniques like replicating, tracking, and fundamental indexing.

• Risk budgeting involves determining benchmark, tracking error, asset allocation, and building a portfolio.

• Active management includes enhanced active investing, long-short strategies, and portable alpha.

• Derivatives can be used to reduce systematic risk and change asset mix in a portfolio.

• Tax considerations vary for different management styles, with active management adding value in tax-exempt environments.

• Exchange-traded funds (ETFs) offer transparency, diversification, tax efficiency, and liquidity for portfolio managers.

Managing Fixed Income Portfolios: Trading Operations, Management Styles, and Box Trades

The document discusses various aspects of fixed income trading operations, including bond management styles, box trades, and active portfolio management strategies. It covers topics such as repo transactions, passive and active bond management styles, and target date immunization. Key terms and strategies are defined and explained in detail.

INTRODUCTION

Bond portfolio management involves passive or active strategies, with a focus on the yield curve. It includes selecting bonds of different maturities and issuers, managing cash flows, and making strategic changes based on economic forecasts. Active management techniques are used to profit from yield spreads and anticipate interest rate changes.

FIXED INCOME TRADING OPERATIONS

This section discusses the collaboration and roles of fixed income portfolio managers and traders.

• Medium to large investment firms divide fixed income duties into portfolio manager and trader roles.

• Small firms have the portfolio manager perform both roles.

• Portfolio managers are responsible for economic analysis and strategy, while traders focus on transaction execution.

• Effective communication and recognition of each other's skills are crucial for success.

• Some institutional managers cannot use leverage or short selling, while others can.

• Traders at broker/dealers leverage their portfolios using repo transactions.

• Portfolio managers must consider financing costs when entering trades.

• Buy-side portfolio managers and sell-side traders have different goals and limitations in fixed income markets.

BOND MANAGEMENT STYLES

This section discusses bond portfolio management techniques, passive and active styles, duration, interest rate risk, and strategies like buy-and-hold and immunization.

• Bonds can be managed passively or actively, with active management aiming to profit from interest rate risk.

• Duration measures a bond's sensitivity to interest rate changes and aids in immunizing a portfolio.

• Buy-and-hold strategy involves holding bonds to maturity to avoid interest rate risk.

• Barbell and laddered portfolios help achieve a yield to maturity equal to a bond's original coupon rate.

• Bond index funds replicate bond indexes using cellular sampling or tracking error minimization.

• Immunization protects a bond portfolio from interest rate risk, with strategies like matching duration and cash flow.

• Contingent immunization involves protecting a portfolio against further losses once a trigger point is reached.

• Interest rate anticipation strategies involve riding the yield curve to benefit from changes in interest rates.

BOX TRADES

This section explains the mechanics and rationale of fixed income box trades involving bond swaps.

• Bond swaps involve purchasing one bond and selling another to profit from yield spread analysis.

• Portfolio managers use historical yield spread data to determine if a swap is warranted.

• Reversing a fixed income swap involves selling the purchased bond and buying the sold bond.

• Box trades involve simultaneous execution of related fixed income security swaps.

• Portfolio managers use box trades to profit from potential market revaluation of yield spreads.

• Constraints of a box trade include no change in portfolio duration, credit risk exposure, or issuer exposure.

• Popular types of box trades include intermarket domestic and intramarket box trades.

• Gains and losses in box trades occur based on the narrowing or widening of yield spreads between bonds.

SUMMARY

This section covers repo transactions, buy-side vs sell-side professionals, passive vs active bond management, duration properties, passive bond management strategies, target date immunization, contingent immunization, and active portfolio management strategies.

• A repo transaction involves selling a security at an agreed price and buying it back at a set price on a future date.

• Buy-side and sell-side fixed income professionals differ in goals, source of assets, and compensation.

• Passive bond management avoids predicting interest rates, while active management aims to profit from interest rate risk.

• Duration properties include the sum of individual bond durations and the impact of coupon rate and yield to maturity.

• Passive bond management strategies include buy-and-hold, barbell and laddered portfolios, and bond index funds.

• Target date immunization matches a portfolio's duration with the payout timing, while contingent immunization involves active management until a trigger point.

• Active portfolio management strategies include interest rate anticipation and box trades involving related fixed income security swaps.

LEARNING OBJECTIVES

The text discusses MBS, ABS, CDOs, foreign currency instruments, real return bonds, derivatives, high-yield bonds, and fixed income ETFs. It covers the structure, management, and characteristics of various fixed income investments.

KEY TERMS

Definitions of key financial terms like ABS, CDO, CDS, and SPV are provided. Tranches and recovery rates are also explained.

INTRODUCTION

Fixed income portfolio management includes alternative instruments, derivatives, high yield bonds, and ETFs. It involves risk management products to control bond portfolio volatility.

OTHER BOND PORTFOLIO CONSTRUCTION TECHNIQUES

The section discusses creating ABS through securitization and credit enhancement facilities.

• Modern instruments like ABS and derivatives are used in portfolio management.

• Securitization turns illiquid assets into tradable securities.

• Receivables like home equity loans and auto loans can be securitized.

• ABS are a type of bond with cash flows supported by underlying assets.

• ABS offer competition to T-bills and commercial paper.

• ABS are created by selling assets to a special purpose vehicle (SPV).

• Credit enhancement facilities are used to reduce credit risk for investors.

EXTERNAL CREDIT ENHANCEMENTS

Third-party guarantees like bond insurance and pool insurance can reduce credit risk in ABS by providing first-loss protection up to a specified level. A letter of credit, an unfunded commitment by a third party, can also enhance credit. Protection is limited to a fixed percentage of collateral.

INTERNAL CREDIT ENHANCEMENTS

This section discusses internal credit risk reduction strategies in Asset-Backed Securities (ABS) such as senior/subordinated structure, cash flow waterfall, reserve funds, and overcollateralization. It also explains Mortgage-Backed Securities (MBS) and their benefits.

• Senior/subordinated structure in ABS establishes layers of ownership, with senior positions having priority in payment over junior positions.

• Cash flow waterfall prioritizes interest and principal payments in ABS, with excess spread seeding reserve funds.

• Overcollateralization in ABS involves issuing less principal than the underlying assets to provide a cushion against defaults.

• MBS were first created in the U.S. in 1970 by Ginnie Mae and later imitated in Canada by CMHC.

• MBS offer higher-yielding investments comparable to government bonds, adding liquidity to the market.

• MBS are guaranteed by CMHC, making them secure investments with a yield premium compared to government bonds.

• Prepayment risk in MBS is influenced by factors like housing turnover, cash-out refinancing, and rate/term financing.

• Misjudging prepayment risk can lead to lower yields on MBS than expected from underlying mortgages.

EXAMPLE

This section covers CDOs, MBS, ABS, CMO, swaps, and portfolio management strategies.

• A person can refinance a $400,000 residence, pocketing $50,000.

• CMO divides MBS pool into tranches based on mortgage cash flows.

• CDO repackages underlying assets into tranches with different risk profiles.

• SPV in CDOs protects investors from originator's default.

• Synthetic CDO swaps credit risk to SPV using CDS.

• CDOs are used to enhance debt quality, increase liquidity, and benefit from yield differences.

• Portfolio managers use swaps and futures to hedge against interest rate risk.

• Credit derivatives manage credit risk by transferring it to speculators or investors.

THE ROLE OF CREDIT DERIVATIVES

This section explains credit derivatives, their purpose, structure, and advantages in financial markets.

• Credit derivatives transfer credit risk between protection buyer and seller.

• Credit derivatives diversify bond portfolios and reduce credit risk efficiently.

• Credit default swaps (CDS) are the most basic form of credit derivatives.

• A CDS involves fee payments and conditional payments upon credit events.

• Payment modes for CDS include physical and cash settlements.

• Securitization offers advantages like reduced funding costs and asset protection.

• Securitization accelerates earnings for loan originators and diversifies funding sources.

• Disadvantages of securitization include lack of transparency in underlying assets and pricing challenges.

HIGH-YIELD (JUNK) BONDS

This section discusses high-yield bonds, credit ratings, default rates, and bond credit-rating agencies.

• High-yield bonds have non-investment-grade credit ratings of Ba1/BB+ or lower.

• Original issuers and fallen angels are the two major sources of high-yield bonds.

• Institutional investors primarily hold high-yield bonds due to their credit risk and complexity.

• Bond credit ratings are provided by Moody's, S&P, and Fitch based on fundamental credit analysis.

• Default rates in the high-yield bond market are calculated based on missed payments, bankruptcies, and restructurings.

• Recovery rates for defaulted bonds are calculated as the amount realized by creditors divided by the face value.

• Credit spreads of high-yield bonds react quickly to credit-rating changes and corporate announcements.

• High-yield bond issuers often use unique coupon structures like deferred coupon bonds and payment-in-kind bonds to conserve cash.

FIXED INCOME EXCHANGE-TRADED FUNDS (ETFs)

The section discusses the growth and structure of Canadian fixed income ETF market.

• Canadian fixed income ETFs had $76.49 billion in AUM as of September 30, 2022, representing 24.5% of the total Canadian ETF industry's assets.

• Fixed income ETFs offer customized exposures to various fixed income securities traded on domestic and international markets.

• ETFs are structured to track passive investment benchmarks, either standardized or customized by ETF managers.

• Investment guidelines and restrictions are set to ensure ETFs meet their performance benchmarks.

• Factors considered in setting benchmarks and guidelines include interest rate risk, credit risk, and currency risk.

• Interest rate risk is managed by setting limits on weighted average term to maturity or duration.

• Credit risk exposure is managed through different mandates like corporate bond ETFs, investment-grade corporate bond ETFs, and high-yield bond ETFs.

• Currency risk is addressed by deciding whether to hedge against potential adverse currency movements.

INVESTMENT MANAGEMENT TECHNIQUES FOR FIXED INCOME ETFs

This section discusses ETF investment management techniques, including replication, statistical sampling, and synthetic replication, to minimize tracking error and achieve performance benchmarks.

• The primary objective of an ETF’s investment management is to track the fund’s performance benchmark closely over time.

• Management fees impact an ETF's rate of return, with higher fees leading to larger tracking errors.

• ETF managers use passive investment strategies like replication, statistical sampling, and synthetic replication to minimize tracking error.

• Replication involves exact replication of securities in the benchmark, while statistical sampling uses statistical techniques to create a portfolio with minimal tracking error.

• Synthetic replication involves a total return swap with a derivative counterparty, offering customization and known tracking error in advance.

• A TRS carries counterparty credit risk, with potential financial implications if the swap counterparty fails.

SUMMARY

This section covers various fixed income securities, derivatives, high-yield bonds, and ETFs in detail.

• Mortgage-backed securities (MBS) offer secure higher-yielding investments comparable to government bonds.

• Asset-backed securities (ABS) have cash flows supported by underlying assets like home equity loans and student loans.

• Derivatives like interest rate swaps and credit default swaps are used in fixed income portfolio management.

• High-yield bonds have non-investment-grade credit ratings and use coupon structures like deferred coupons and PIK bonds.

• Fixed income ETFs track passive investment benchmarks using strategies like replication and statistical sampling.

The Permitted Uses of Derivatives by Mutual Funds

Mutual funds use derivatives for hedging and non-hedging purposes, following regulations and disclosures. Advantages and risks are considered.

INTRODUCTION

Mutual funds are slowly increasing their use of derivatives due to competitive pressure for higher returns. Regulations governing the use of derivatives in mutual funds are discussed, along with potential advantages and disadvantages for investors.

THE TYPES OF MUTUAL FUNDS THAT USE DERIVATIVES

Many mutual funds use derivatives, financial contracts whose value depends on other assets like stocks or commodities. Index funds, like the S&P 500, often use derivatives to replicate market index returns and manage cash balances efficiently. Derivatives help funds meet redemptions and access index returns quickly.

MUTUAL FUND REGULATIONS

This section discusses Canadian mutual fund regulations, including the use of derivatives for hedging and non-hedging purposes.

• Canadian mutual fund regulations are governed by Securities Acts of provinces or territories.

• National Instruments (NIs), particularly NI 81-102, control mutual fund activities.

• NI 81-102 permits the use of derivatives in mutual funds for risk reduction.

• Derivatives allowed include options, futures, forwards, and swaps.

• Specific guidelines in NI 81-102 include minimum credit ratings for counterparties and exposure limits.

• Derivatives can be used for hedging purposes to offset specific risks.

• Currency cross-hedges are allowed, substituting exposure to one currency risk for another.

• Derivatives can also be used for non-hedging purposes to gain market exposure without owning underlying securities.

HOW MUTUAL FUNDS USE DERIVATIVES

This section discusses the use of derivatives in Canadian mutual funds for hedging and non-hedging purposes.

• Canadian mutual funds use derivatives to hedge exchange rate exposure from foreign securities.

• Managers use forward contracts to lock in exchange rates for U.S. dollar and Japanese yen exposure.

• Derivatives are also used for additional income, exposure to markets, and risk reduction.

• Selling covered call options can generate income and manage stock positions effectively.

• Writing put options can provide attractive entry prices for buying underlying securities.

• Bond futures and OTC derivatives are used to manage duration in fixed income mutual funds.

• Index funds can be created using derivatives like forwards, futures, and swaps.

• Total Return Index Swaps can be used to gain exposure to index returns while holding Treasury bills.

THE ADVANTAGES OF DERIVATIVES

Overview of the advantages of using derivatives in mutual funds for risk reduction, cost savings, asset selection, and portfolio income.

• Derivatives help mutual fund managers reduce currency exposure associated with foreign investments.

• Managers can use derivatives to quickly and cost-effectively purchase diverse securities in a single transaction.

• Stock index forwards can be utilized for asset allocation strategies, reducing transaction and administration costs.

• Derivatives provide access to markets that may be difficult to enter, such as emerging markets.

• Covered call options can increase portfolio income, but there is a risk of missing out on potential returns if securities rally.

THE POTENTIAL RISKS OF DERIVATIVES

This section discusses the disadvantages and risks associated with using derivatives in mutual fund management.

• Not all mutual fund managers use derivatives due to risks such as income considerations, expiration dates, and limited gains.

• Derivatives contracts have expiration dates, and the costs and administration of expiry may be an issue.

• Using derivatives for hedging may not provide adequate protection if there is a weak correlation between securities and derivatives.

• Derivatives are often used to hedge foreign currency investments or interest rates, but incorrect forecasts can lead to losses.

• Tax considerations are important, as income from futures and forward contracts is taxed as ordinary income.

• Mutual funds using derivatives may have higher costs due to extra administrative and management costs.

• Funds using derivatives are exposed to counterparty risk, especially when using OTC derivatives contracts.

• Canadian mutual fund regulations require disclosure of derivatives use in a fund's prospectus, but understanding the true exposure may be difficult for average investors.

SUMMARY

This section covers types of mutual funds using derivatives, regulations, disclosures, hedging vs non-hedging, ways of using derivatives, advantages, and disadvantages.

• Certain mutual funds, particularly index funds, are more likely to use derivatives.

• NI 81-102 in Canada outlines permitted derivative activities for mutual funds.

• Derivatives must be disclosed in a mutual fund's prospectus, explaining their use and risks.

• Advantages of using derivatives include risk reduction, lower costs, and greater asset selection.

Creating New Portfolio Management Mandates

The process of developing new investment products involves analyzing market size, legal issues, financial forecasting, and following steps post-approval. Investment guidelines and restrictions are crucial for a well-defined investment policy.

INTRODUCTION

Investment management firms develop various products like mutual funds, ETFs, and managed accounts. They assess new products through key steps, guidelines, and restrictions to reach a final decision. Distribution channels offer opportunities to sell expertise to a range of investors.

NEW INVESTMENT PRODUCT DEVELOPMENT PROCESS

This section discusses the steps involved in developing new investment products and the role of portfolio management skills.

• The investment management industry creates new products by identifying market opportunities and assessing the market.

• Eight key steps in developing new investment products include market assessment, legal considerations, and financial forecasting.

• Product ideas can be "pulled" from the market or "pushed" by the investment management firm.

• Large firms have product management teams responsible for new product development, while smaller firms may rely on functional teams.

• A well-designed product development process should be tailored, thorough, and data-driven.

• Active investment products rely on portfolio management skills, while passive products focus on cost control and operational efficiency.

• Investment firms may use internal or external portfolio managers, depending on the target market and product type.

• Outsourcing portfolio management skills is common for global investment mandates to save costs and time.

DIVE DEEPER

This section discusses backtesting, market assessment, and new investment products meeting investor needs.

• Backtesting is used to assess investment team skills for managing new products.

• Regulators have concerns about potential misrepresentation of backtesting results in sales and marketing materials.

• Market assessment factors include economy tone, recent performance, and distribution capabilities.

• New investment products meeting investor needs include exposure to industry themes and ETFs.

• ETFs have grown substantially in the past 15 years due to lower fees and easy trading.

• Assessing the market for a novel product is challenging without benchmarks.

• Financial innovations are not patentable, leading to quick market entry by competitors.

• Being first to market with a new fund can lead to quick and profound competitive responses.

STEP FOUR: DETERMINING LEGAL AND REGULATORY RESTRICTIONS

The section discusses regulations, structures, marketing challenges, and financial projections for Canadian investment products.

• Mutual funds are the most regulated Canadian investment products, usually structured as unit trusts or corporations.

• Exempt or accredited investor products like hedge funds do not require an approved prospectus.

• Offshore funds bring additional risks due to different legal and regulatory requirements.

• Marketing strategies for new funds focus on unique investment manager skills or innovative market opportunities.

• Financial forecasts for new products include net sales, market growth, and investment management fees.

• AUM growth is influenced by net sales, positive investment performance, and market growth.

• Investment management fees vary based on fund type, with equity funds having the highest fees.

• Pro forma financial projections are crucial for decision-making on new fund launches.

DID YOU KNOW?

This section discusses the challenges and risks associated with launching a new investment fund. It covers factors affecting sales, consequences of failure, and steps involved in product development.

• Weak market conditions can hamper new fund sales, leading to direct financial loss and loss of marketplace stature.

• Large fund managers face fewer consequences from failed launches compared to small to medium-sized firms.

• The process of developing and launching a new investment product typically takes three to four months for mutual funds or ETFs.

• Products targeting exempt or accredited investors can be ready for sale in less than two months.

• Establishing the product's legal structure is one of the first steps in the development process.

• Existing firms often retain third-party service providers for new products, leading to competitive fees and shorter timelines.

• Distribution agreements are required for most new investment funds, with established managers having an advantage in sourcing and negotiating agreements.

• Sales and marketing materials are crucial for new fund launches, targeting both distributors and prospective investors.

INVESTMENT GUIDELINES AND RESTRICTIONS

This section discusses the importance of investment guidelines and restrictions for new funds, covering topics such as investment objectives, geographic focus, performance benchmarks, sector guidelines, issuer restrictions, and asset mix policies.

• Industry best practices require unique investment guidelines and restrictions for each fund.

• Investment objectives include capital preservation, income, and capital appreciation.

• Funds may focus on domestic, international, or global markets with specific geographic restrictions.

• Investment guidelines set limits on country and region exposure to manage risk.

• Sector and issuer restrictions control fund exposure to specific industries and companies.

• Balanced funds have target asset mix policies for equities, bonds, and cash.

• Investment managers use tactical asset mix strategies to adjust fund allocations based on market opportunities.

• Fixed income mandates have unique factors such as credit ratings, term to maturity restrictions, and sector-specific mandates.

SUMMARY

This section covers steps for analyzing and developing new investment products, assessing market opportunities, legal issues, financial forecasting, and project approval.

• Eight key steps for assessing and developing new investment products are outlined.

• Assessing investor needs is crucial for identifying market opportunities.

• Legal and regulatory issues for new investment products are discussed, including prospectus requirements.

• Financial forecast requirements include net sales, market growth, and fees.

• Steps after project approval involve establishing information flows, legal structure, and distribution agreements.

• Investment guidelines and restrictions ensure fund objectives are met and reduce potential litigation.

• Having a well-defined investment policy leads to improved return consistency and higher AUM.

Alternative Investments

The text discusses the characteristics, challenges, and risks of alternative investments, including hedge funds and real estate. It also covers factors driving the growing interest in alternative investments and the importance of due diligence in the investment process. The text highlights the need for proper management of issues such as liquidity dates, transparency risk, and performance attribution. The asset allocation process is also explored in relation to including alternative investments in a portfolio. The text concludes by discussing the primary trends and developments in the alternative investment management industry.

INTRODUCTION

Institutional investors moving from public to alternative markets due to uncertain equity and bond returns.

DEFINITION OF ALTERNATIVE INVESTMENTS

This section discusses various alternative investment categories, including hedge funds, private markets, real estate, and commodities. It also covers the characteristics, strategies, and structures of alternative investments.

• Alternative investments have different performance characteristics from traditional assets like stocks and bonds.

• Hedge funds offer flexibility in investment strategies, including short positions and leverage.

• Commodities can be invested in directly or indirectly through derivatives.

• Private market funds are typically structured as limited partnerships with specific investment phases.

• Real estate is considered an alternative investment with both private and public forms.

• REITs provide exposure to real estate assets and are publicly traded for liquidity.

• Alternative investments offer higher risk-adjusted returns and lower correlation to traditional assets.

• They also have less liquidity, limited benchmark availability, and higher investment management fees.

REASONS TO INVEST IN ALTERNATIVE INVESTMENTS

Interest in alternative investments has grown since the 1990s, with a significant increase post-2000. Reasons include technology-led market sell-offs and low bond yields. Alternative investments offer unique benefits not found in traditional investments.

ISSUES AND CHALLENGES WITH ALTERNATIVE INVESTMENTS

The section discusses challenges in alternative investments, including asset allocation, pricing, and leverage management.

• Start-up alternative investment managers face operational challenges and risks due to their lack of experience in managing alternative investments.

• Institutional investors struggle with determining the appropriate asset allocation policy for alternative investments.

• Historical pricing data may not accurately reflect the true economic exposure of assets in the analysis of asset mix policy allocations.

• Mean-variance models like MPT may not be suitable for alternative investments due to skewed return distributions.

• Security pricing for alternative investments is a mix of art and science, leading to pricing risks.

• Short sale transactions introduce operational risks for investment managers, especially those with limited experience.

• Financing and leverage management are crucial in alternative investment strategies, particularly in hedge funds.

• Real-time information on margin balances and leverage is essential for investment managers to ensure compliance with guidelines and restrictions.

PERFORMANCE ATTRIBUTION

The section discusses challenges in performance attribution for alternative investment funds and the lack of industry standards.

• Performance attribution for alternative investment funds is difficult due to the lack of publicly traded securities and realistic values.

• Unrealistic security pricing can lead to inaccurate net asset value (NAV) calculations and performance attribution.

• Third-party performance index providers exist for alternative investment mandates, but data may not be audited or verified.

• There are no industry-wide agreed-upon standards for alternative investment funds and their strategies.

• Lack of transparency in investment manager strategies affects accurate performance evaluation and assessment.

• Some hedge fund strategies, like global macro, have wide latitude, making peer performance comparisons challenging.

• Performance index providers face challenges in ensuring accurate and truthful data from fund managers.

• The subjective nature of security pricing can render the performance attribution exercise meaningless.

THE UNIQUE RISKS OF ALTERNATIVE INVESTMENTS

This section discusses various risks associated with investing in alternative asset classes, including transparency risk, liquidity risk, and pricing risk.

• Alternative investments lack transparency due to private placements and may involve fraud or style drift.

• Due diligence is crucial for investors to understand the manager's strategies and risks.

• Liquidity risk is evident in private market and real estate investments, as well as hedge funds.

• Lockup periods can restrict investors from redeeming their investments in alternative funds.

• Tax implications vary for different alternative investment structures, impacting investor returns.

• Pricing risk exists in real estate and private market funds, as well as hedge funds with illiquid securities.

• Counterparty risk arises when the other party fails to honor financial commitments, affecting fund transactions.

• Business risk in alternative investments is high due to small, undercapitalized management firms.

DUE DILIGENCE

This section discusses the objectives, process, and key areas of performing due diligence on investment funds.

• Due diligence is a thorough investigation of investment worthiness and risk assessment.

• Four main factors to consider when investing in a fund are expertise, strategies, performance, and structure.

• Due diligence process involves screening, identifying opportunities, full reviews, and continuous monitoring.

• Eight main areas to address in due diligence include structure, risk analysis, operations, and performance.

• Advisors have more access to information about alternative investment funds than clients.

• Questions to address in assessing an alternative investment fund's risk profile are provided.

• Various aspects such as leverage, hedging strategies, risk controls, and market environment should be considered.

• Legal, taxation, and regulatory issues, as well as the fund manager's track record and stability, are important factors to evaluate.

CURRENT TRENDS AND DEVELOPMENTS IN ALTERNATIVE INVESTING

The section discusses the evolution of alternative investments, including regulatory oversight, institutionalization, and the rise of digital assets.

• There is an increasing call for more regulatory oversight of the hedge fund industry, especially in the U.S.

• The alternative investment industry is becoming more institutionalized as institutional investors play a bigger role.

• Large institutional investors are standardizing processes and procedures in the alternative investment industry.

• The industry is known for its innovation and rapid growth despite market volatility.

• Digital assets are categorized into crypto assets and non-crypto assets, with a growing acceptance as a legitimate asset class.

• The pandemic has driven institutional adoption of bitcoin and cryptocurrencies by corporate treasuries.

• Fidelity has developed enterprise-grade bitcoin custody and other crypto investment services.

• The availability of various funds, trusts, and ETFs makes it easier for investors to access and manage cryptocurrencies.

SUMMARY

This section covers characteristics, benefits, challenges, risks, due diligence, and trends in alternative investments.

• Alternative investments include hedge funds, private markets, real estate, and commodities.

• Benefits of alternative investments include improved diversification, reduced volatility, and access to unique strategies.

• Challenges for alternative investment managers include asset allocation, security pricing, and leverage accounting.

• Asset allocation models for alternative investments need modifications due to skewness and kurtosis.

• Performance attribution for alternative investments faces issues like lack of benchmarks and transparency.

• Risks of alternative investments include regulatory oversight, transparency, manager and market risk, and liquidity risk.

• Due diligence process for alternative investments involves screening, analysis, and continuous monitoring.

• Trends in the alternative investment industry include increased regulation, institutionalization, innovation, and digital assets.

Client Portfolio Reporting and Performance Attribution

Most institutional investment firms comply with GIPS, include book and market prices in reports. Performance attribution evaluates manager skills. Style drift explained.

KEY TERMS

The text covers key terms like GIPS, style analysis, and settlement in portfolio management.

INTRODUCTION

This chapter discusses GIPS, portfolio management reports, settlement process errors, performance attribution analysis.

CLIENT PORTFOLIO REPORTING

This section discusses the importance of GIPS standards in the investment management industry.

• GIPS standards aim to present investment performance fairly and ethically to clients globally.

• Compliance with GIPS standards is voluntary but offers benefits for firms and clients.

• Over 40 countries, including Canada and the U.S., have adopted the GIPS standards.

• Firms must define themselves clearly and avoid misrepresenting their performance.

• Composites must include all fee-paying discretionary portfolios and follow specific rules.

• Data used for performance calculations must be based on fair values and valued at specific frequencies.

• Calculation methodologies, such as total return and time-weighted returns, are specified by GIPS standards.

• Presentation and reporting guidelines require composites to show at least five years of performance data.

PORTFOLIO MANAGEMENT REPORTS

This section discusses the importance of portfolio management reports, including their contents, frequency, and tax implications.

• Portfolio management reports provide detailed information on a fund's holdings and performance for institutional clients.

• These reports include data on security holdings, market values, book values, and unrealized gains or losses.

• Issuer information is grouped by industry sector, and holdings are further grouped by asset class.

• Quarterly and yearly reports include information on sector holdings, rate of return, performance attribution, and market outlook.

• Market prices are used for risk management and performance measurement, while tax implications require tracking historical costs.

• Tax implications also involve measuring foreign investments in Canadian dollars for tax purposes.

• The clearing and settlement of trades is a time-consuming process prone to errors, with discrepancies between manager's and custodian's records.

• Effective May 27, 2024, the proposed settlement date change in Canada is to one business day after the trade date.

PERFORMANCE ATTRIBUTION

This section explains the importance of portfolio performance attribution, breaks down the process, and discusses sector attribution in equity and bond portfolios.

• Portfolio performance attribution evaluates a manager's decisions, ensuring investment objectives are met.

• It breaks down a portfolio's return into asset allocation and security selection components.

• An example calculation shows how excess return is attributed to asset allocation and security selection.

• Sector attribution in an equity portfolio involves analyzing sector weights and returns to determine allocation and selection effects.

• A bond portfolio's attribution process is more complex and requires specialized software.

• Style analysis is crucial to understand a fund's investment style and potential style drift.

• Returns-based and holdings-based style analysis methods are used to determine a fund's investment style.

• Attributing for style drift involves tracking a portfolio's style proportions over time to identify any shifts.

SUMMARY

This section covers GIPS standards, portfolio management reports, performance attribution, and style drift.

• GIPS standards aim to present investment performance fairly and ethically to clients.

• Portfolio management reports include detailed information on holdings and performance.

• Performance attribution analysis evaluates a portfolio manager's skills through four steps.

• Style drift can make it difficult to assess a fund's risk level and manager's skills.

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