MODULE 84.2: THE CAPM AND THE SML

MODULE 85.1: PORTFOLIO MANAGEMENT PROCESS

1. Do not imagine portfolio management as “pick a few stocks and pray.” The process is much more boring and much more powerful. First you understand the person, then you write the rules, then you build the portfolio, then you keep checking whether real life has changed.

INVESTMENT POLICY STATEMENT

1. The starting document is the investment policy statement (IPS). This is the written game plan. It tells you what the client is trying to achieve and what the portfolio is not allowed to do.
2. In plain English, the portfolio management process is:
   1. Know the client.
   2. Write the investment policy statement.
   3. Translate that into a strategic asset allocation (SAA), which means the long-run mix of asset classes.
   4. Implement the portfolio.
   5. Monitor drift, review changes, and rebalance when needed.
3. This is why professionals love written policy. A written plan saves you from emotional stupidity. In every bubble and panic, the real damage usually comes from people changing the rules in the middle of the match.
4. Think of the dot-com bubble, the 2008 crisis, or the meme-stock frenzy. In all of them, people suddenly discovered a new religion called “this time is different.” A proper portfolio process exists to stop you from doing something dramatic just because prices are screaming.

1. A good IPS also helps with accountability. If a manager buys something wild and later says, “Trust me, I had a feeling,” the IPS lets you ask a better question: “Was this actually suitable for the client?”
2. For institutional investors such as pension funds or endowments, the IPS can also describe governance. In simple words, it tells you who decides what, who hires managers, and who is allowed to change the rules. IPS needs regular review, especially when the client’s life changes.

1. The heart of the IPS is two-part:
   1. Investment objectives: what the client wants.
   2. Investment constraints: what limits the way the client can pursue those wants.
2. This sounds simple, but this is exactly where most mistakes happen. People often focus only on return and forget that a portfolio also has to survive withdrawals, taxes, legal restrictions, and the client’s own nerves.

1. Risk objective means: how much uncertainty, loss, or benchmark deviation the client can tolerate. Return objective means: what the client needs or wants the portfolio to earn. These two must agree with each other.

1. The reading also separates willingness to take risk from ability to take risk. Willingness is psychological. Ability is financial.
2. This distinction matters a lot. A young founder may be emotionally fearless but financially concentrated because all her wealth and salary already depend on one business. She may be willing to gamble, but her actual ability to take more risk may be lower than her ego suggests.
3. The reverse also happens. Someone may have huge financial capacity to take risk but still panic at every red screen. A portfolio that looks good in a spreadsheet but causes the client to sell at the worst moment is not a suitable portfolio.

1. The major constraint buckets are worth hammering into your head:
   1. Liquidity needs: how much cash must come out, and when.
   2. Time horizon: how long the money can stay invested before it is needed.
   3. Tax concerns: who gets taxed, when, and how heavily.
   4. Legal and regulatory factors: what the client is allowed or required to do.
   5. Unique circumstances: anything special, including personal restrictions or environmental, social, and governance preferences.
2. Liquidity is one of the easiest ways to blow up a good-looking portfolio. If the client needs cash soon, you cannot hide the money in beautiful but hard-to-sell assets and then act surprised. This is the same basic lesson the world keeps relearning in every funding squeeze: an asset can be “valuable” and still be a terrible answer to an immediate cash need.
3. Time horizon changes everything. Money needed in six months should not be treated like money meant for retirement in 25 years.
4. Taxes matter because the investor does not spend pre-tax fantasy returns. The investor spends what remains after the tax authority takes its cut.
5. Legal and regulatory constraints matter especially for institutions. Some investors are simply not free to invest anywhere they want.
6. Unique circumstances catch everything else that matters. This can include concentration issues, family values, or exclusion of certain industries.
7. The reading also allows environmental, social, and governance (ESG) preferences to be built into policy. That means the portfolio process is not only about risk and return in a narrow sense. It can also reflect what the client refuses to own or actively wants to support.

STRATEGIC ASSET ALLOCATION

1. Once the investment policy statement is clear, the next big job is building the long-run asset mix. This is the strategic asset allocation (SAA).
2. Asset classes are the building blocks here. An asset class is just a group of assets with similar features and similar risk-return behavior. Traditional big buckets are cash, equities, bonds, and real estate. Many investors now also include things such as private equity, hedge funds, commodities, or infrastructure under alternative investments.
3. The strategic asset allocation is the baseline mix of these asset classes that is expected to meet the client’s long-term objectives while respecting the constraints. It comes from the investment policy statement plus capital market expectations. It is not supposed to be the manager’s mood of the week.
4. Capital market expectations mean your views on expected return, risk, and correlation across asset classes.
5. Correlation matters because combining assets that do not move together can improve the risk-return trade-off. That is the boring superpower of diversification.
6. This is why the process cares so much about asset allocation. Over the long run, the major swings in portfolio value mostly come from systematic exposures across asset classes, not from one genius stock tip.
7. Defining asset classes properly is also important. If you split equities into domestic, international, developed market, and emerging market buckets, you are choosing to control those exposures explicitly.
8. A finer split gives more control, but it also demands better estimates and more discipline. A broad split is simpler, but then the manager gets more freedom inside the bucket.
9. There is no magical list from heaven. The asset classes should be internally similar enough to make sense as a group, but different enough from other classes to provide diversification.

IMPLEMENT THE PORTFOLIO

1. At this stage, the manager decides where risk should come from beyond the policy mix.
2. The reading highlights three broad sources of return:
   1. Strategic asset allocation: the long-term policy mix.
   2. Tactical asset allocation: short-term deviations from policy weights when the manager thinks some asset classes will do better or worse.
   3. Security selection: picking specific securities expected to beat their benchmark.
3. Tactical asset allocation means saying, “For now, I want a little more equities and a little less bonds than policy says,” because of a shorter-term view. Security selection means trying to own the better securities within an asset class.
4. Both can add value, but both also add extra uncertainty beyond the policy portfolio. The curriculum is very clear here: policy risk is one thing, extra active risk is another.

1. That is why portfolio managers often think in terms of risk budgeting, which means deciding how much total risk is acceptable and how much of that risk should be spent on different activities. This is a useful way to think: risk is a budget, not an unlimited buffet.
2. The reading also draws a sharp line between active and passive management. Active management tries to beat the benchmark through tactical calls or security selection. Passive management mainly tries to match the benchmark at low cost.
3. The big warning is brutally simple: active management is a zero-sum game before costs and a negative-sum game after costs for the average investor.
4. In plain English, if everyone is trying to outsmart everyone else, the average person cannot beat the market after paying research teams, trading costs, and management fees.
5. That does not mean skill never exists. It means you should not assume skill as your default religion. The financial world has a long history of people looking brilliant in easy years and blowing up in hard years. The process tries to protect the client from paying genius-level fees for ordinary-level results.
6. Real portfolios drift. If equities rise a lot, the equity weight becomes larger than intended. If bonds rally while stocks fall, the bond weight may become too high. This movement away from target weights is called drift. The fix is rebalancing, which means bringing the portfolio back toward the policy weights, either on a schedule or when weights move beyond allowed bands.
7. Rebalancing sounds mechanical, but it quietly enforces discipline. It makes you trim what has run too far and add to what has become too small.
8. Many investors hate doing that in the moment because it feels wrong emotionally. You are often selling what recently made you feel smart and buying what recently embarrassed you. That discomfort is exactly why rebalancing matters.

MODULE 85.2: ASSET MANAGEMENT AND POOLED INVESTMENTS

1. Asset Management simply means: you hand money to somebody else and ask them to manage it in a structure that matches your needs.
2. The big question is not just “what return can I get?” The real question is “what wrapper am I buying?” because the wrapper decides liquidity, fees, taxes, control, and even whether you actually own the underlying assets.
3. The main pooled and managed products in this reading are: mutual funds, separately managed accounts, exchange-traded funds, hedge funds, and private equity or venture capital funds.

1. A mutual fund is a commingled pool. Investors own shares in the fund, and each investor has a pro-rata claim on the income and value of the portfolio.
2. The value of a mutual fund is its net asset value (NAV), which is based on the closing value of the securities in the portfolio and is usually computed daily.
3. Mutual funds became huge because they solve several problems at once: low minimum investment, diversification, daily liquidity, and standardised reporting. In plain English, mutual funds are the “I do not want to build this portfolio myself” solution.
4. Vanguard launched the first index fund in 1976. That was a big cultural shift because it basically told investors, “Stop pretending every manager is a genius. Just track the market cheaply.”

1. Open-end mutual fund means the fund accepts new money and creates new shares, and it also redeems shares when investors want out.
2. If new money comes in, the fund issues new shares at the current NAV. If investors redeem, the fund must give cash back at NAV and may need to sell portfolio assets.
3. That is the hidden headache of open-end funds: the manager is not just picking securities; the manager is also constantly dealing with cash coming in and cash going out.
4. During stressed markets, this can get ugly because the fund may be forced to sell assets it did not want to sell. You see versions of this pressure during market panics when redemption accelerated and managers suddenly cared a lot about liquidity.
5. Closed-end mutual fund means the number of shares is fixed. New investors buy existing shares from other investors instead of the fund issuing new ones. Because those shares trade in the market, a closed-end fund can trade at a premium or discount to NAV.
6. This is a classic exam contrast:
   1. Open-end fund transactions happen at NAV.
   2. Closed-end fund shares can trade away from NAV because market demand and supply determine price.
7. Open-end funds grow more easily, but the manager has to handle inflows and redemptions. Closed-end funds avoid that cash-flow problem, but growth is limited.
8. Mutual funds can also be load or no-load.
9. A load fund charges a sales fee to buy, hold, or redeem. A no-load fund skips that sales charge but still usually charges an annual fee based on NAV.
10. Historically, load funds were often sold through brokers who took part of the upfront fee.
11. Translation: with load funds, part of your money is paying the selling machine, not just the investment machine.
12. The main mutual fund categories by asset type are:
    1. Money market funds
    2. Bond mutual funds
    3. Stock mutual funds
    4. Hybrid or balanced funds
13. Money market funds invest in short-term money market instruments such as Treasury bills, certificates of deposit, and commercial paper. Their goal is simple: preserve principal, stay liquid, and give a return close to money market rates.
14. Some money market funds use a constant net asset value (CNAV), often kept at USD 1 per share. Others use a variable net asset value (VNAV), where the unit price can move.

1. Important trap: money market funds may feel like savings accounts, but they are not insured the same way as bank deposits.
2. Bond mutual funds hold portfolios of bonds, sometimes with preferred shares, and usually invest in securities with much longer maturities than money market funds.
3. Key distinction: money market fund maturities are extremely short, often overnight and rarely beyond 90 days. Bond fund maturities can stretch from about one year to 30 years or more.
4. Bond fund categories in the reading include global, government, corporate, high-yield, inflation-protected, and national tax-free bond funds.
5. Stock mutual funds are the biggest category by assets under management.
6. They come in two broad flavours:
   1. Actively managed funds, where the manager tries to beat the market by selecting stocks.
   2. Index funds, where the goal is simply to track an index.
7. Active funds usually charge more because research, trading, and trying to outperform are expensive habits. Index funds usually have lower fees and lower turnover, and that often means lower tax drag too.
8. This is one of the most useful real-world investing lessons in the whole reading: many people obsess over stock picking, but fees and turnover quietly eat returns year after year.
9. Hybrid or balanced funds mix stocks and bonds in one fund.
10. A popular version is the lifecycle or target-date fund. It changes the asset mix gradually as the target retirement date gets closer.
11. If you are far from retirement, the fund may hold mostly stocks. As retirement approaches, it shifts more toward bonds. It is just automated de-risking.

SEPARATELY MANAGED ACCOUNT

1. A separately managed account (SMA) is different from a pooled fund. It is managed for one client only. In an SMA, the client owns the assets directly. In a mutual fund, the investor owns shares of the fund. This is the whole SMA pitch: customization.
2. If a pension fund says, “I want large-cap value stocks, but exclude tobacco and defense and respect environmental, social, and governance preferences,” an SMA can do that much more easily.
3. The downside is obvious: SMAs usually require much higher minimum investment amounts, so they are mainly used by large institutions and wealthy investors. Think of a mutual fund as shared public transport and an SMA as hiring your own car. One is cheap and standardized. The other is personal and expensive.

EXCHANGE TRADED FUND

1. Exchange-traded funds (ETFs) are funds that trade on exchanges like stocks and are generally structured as open-end funds.
2. This product exploded in size because it combines diversification with stock-like trading convenience.
3. Key difference versus a mutual fund: an ETF trades intraday. A mutual fund is usually bought or sold only once a day at NAV.
4. ETF investors buy from other investors in the market, can short the shares, and can buy on margin. Mutual fund investors transact directly with the fund, and shorting or margin purchase is generally not allowed.
5. In practice, ETF market prices are usually close to the NAV of the underlying portfolio.
6. Other differences from mutual funds in this reading:
   1. ETFs may have different transaction cost patterns.
   2. ETF dividends are generally paid out to shareholders.
   3. Mutual funds usually reinvest dividends.
   4. ETF minimum investment is usually smaller.
7. Think of BlackRock and the global ETF boom. Investors loved the ability to get broad exposure cheaply without begging a stock picker to be a hero.

HEDGE FUNDS

1. Hedge funds are private investment vehicles that often use leverage, derivatives, and long-short strategies.
2. Typical hedge fund characteristics:
   1. Short selling.
   2. Absolute return focus.
   3. Leverage.
   4. Low correlation with traditional asset classes.
   5. Two-layer fee structure.
3. The famous fee phrase is basically “2 and 20”: around 2% management fee and up to 20% incentive fee, though fee pressure has pushed this down in many cases.
4. Hedge funds are usually not for everyone. They tend to require high minimum investments and may restrict liquidity through quarterly withdrawals or long lockups. Translation: hedge funds offer flexibility to the manager, but often at the cost of simplicity, transparency, and liquidity for the investor.

PRIVATE EQUITY AND VENTURE CAPITAL FUNDS

1. Private equity and venture capital funds buy companies, improve them, and eventually try to sell them for a profit. Unlike public-market managers, they are usually much more hands-on. They may change strategy, install management, alter capital structure, or push operational improvements.
2. The final stage is the exit or harvesting stage, where the investment is sold through a merger, acquisition, or initial public offering.
3. Most of these funds are structured as limited partnerships. The manager is the general partner (GP). The investors are the limited partners (LPs).
4. Their revenue sources in the reading are:
   1. Management fees.
   2. Transaction fees.
   3. Carried interest.
   4. Investment income on GP capital.
5. Carried interest is the GP’s share of profits, typically 20%, and usually kicks in only after LPs recover their initial investment.

1. A very easy way to remember private equity is this: mutual funds mostly own tradable securities, but private equity funds often try to remake the business itself. Private equity and venture capital funds usually have long lives, often around 7 to 10 years, so this is not money you expect to pull out next month.

1. Final intuition: do not memorize these products as random labels. Ask three questions every time:
   1. Who owns the underlying assets?
   2. How do investors get in and out?
   3. Who gets flexibility and who bears the inconvenience?
2. If you answer those three questions, most comparison questions in this module become embarrassingly easy.

MODULE 84.1: SYSTEMATIC RISK AND BETA

1. Split risk into two buckets and life becomes much easier. Systematic risk is the market-wide storm you cannot escape. Non-systematic risk (Idiosyncratic Risk) is the local mess tied to one company or one industry.
2. Systematic risk hits broad chunks of the market together. Think interest rates jumping, inflation getting ugly, a recession, political instability, or a big natural disaster. When 2008 hit, even good businesses got dragged down because the whole system was under stress.
3. Non systematic risk is the "this company specifically messed up" type of risk. A failed drug trial, an airline crash, or a fraud scandal like Satyam in India blowing up because the company itself was rotten. That pain is real, but it does not have to infect every other stock you own.
4. The exam idea is simple: if a risk can be diversified away, the market will not pay you extra for carrying it. You do not get a medal for holding avoidable stupidity.
5. Total variance is split as:

1. Be careful here: This relation is in variance terms, not standard deviation terms.

1. A risk-free asset has zero systematic risk and zero nonsystematic risk.
2. A well-diversified market portfolio has essentially zero nonsystematic risk left. What remains is systematic risk.
3. This is why a diversified investor should care far more about how a stock moves with the market than how wild that stock looks on its own.
4. Beta is the clean summary of that idea. It tells you how sensitive an asset is to market movements.
5. The core formula is:

1. Read that like a human: beta goes up when the asset moves strongly with the market, when the correlation with the market is high, or when the asset is more volatile than the market.
2. Interpretation:
3. Beta = 1 means the asset moves roughly in line with the market.
4. Beta > 1 means it tends to move more than the market.
5. Beta between 0 and 1 means it moves with the market, but more gently.
6. Beta = 0 means no market sensitivity. A risk-free asset has beta zero.
7. Negative beta means it tends to move opposite to the market, though truly consistent negative-beta assets are rare.

1. If correlation with the market is 0.70, asset standard deviation is 25%, and market standard deviation is 15%, then beta is:

That means if the market moves, this asset usually moves in the same direction but with more punch.

INTRODUCTION TO RISK MANAGEMENT

1. The following are financial risks (CMLI):
   • Credit risk – The other side may not pay. Example: A company sells goods on credit; the buyer goes bankrupt and never pays.
   • Market risk – Prices move against you. Example: Equity prices fall in a recession; bond prices fall when interest rates rise.
   • Liquidity risk – You can't sell fast without taking a big price hit. Example: You hold a small-cap stock; in a panic market, you sell much lower than its fair value.
   • Interest rate risk: Risk of prepayments or higher opportunity cost of capital.
2. The following are non-finacial risks (SolRegPolLegModTailOper):
   • Solvency risk – The firm runs out of cash and can't survive. Example: A company can't pay salaries or debt interest and goes bankrupt.
   • Regulatory risk – Rules change and hurt the business. Example: A new capital requirement forces banks to raise equity or cut lending.
   • Political / tax risk – Government actions outside normal regulation hurt profits. Example: Sudden tax hike reduces after-tax earnings of companies.
   • Legal risk – Future lawsuits or legal action cause losses. Example: A firm is sued for mis-selling products and pays heavy penalties.
   • Model risk – Your math or valuation model is wrong. Example: A risk model underestimates losses because it assumes normal distributions.
   • Tail risk – Rare, extreme events happen more often than expected. Example: A 2008-style crash wipes out strategies built for “normal” markets.
   • Accounting risk – Financial statements turn out to be wrong.
     • Example: Aggressive revenue recognition leads to restated earnings later.
   • Operational risk – Loss due to people, process, or system failure. Example: A trading desk loses money because of a fat-finger trade or a cyberattack shuts systems.
3. With a risk transfer, another party takes on the risk. Insurance is a type of risk transfer. The risk of fire destroying a warehouse complex is shifted to an insurance company by buying an insurance policy and paying the policy premiums. Insurance companies diversify across many risks so the premiums of some insured parties pay the losses of others.
4. Risk shifting is a way to change the distribution of possible outcomes and is accomplished primarily with derivative contracts. For example, financial firms that do not want to bear currency risk on some foreign currency denominated debt securities can use forward currency contracts, futures contracts, or swaps to reduce or eliminate that risk.
5. With a surety bond, an insurance company has agreed to make a payment if a third party fails to perform under the terms of a contract or agreement with the organization.
6. Insurers also issue fidelity bonds, which will pay for losses that result from employee theft or misconduct.
7. A funny but important point: a very risky asset does not automatically have a high beta. An initial public offering can have huge standalone volatility, but if that volatility is not tightly linked to market moves, beta may still be modest.
8. Beta can also be estimated from the market model:

1. Here, alpha is the intercept, beta is the slope, and the error term is the company-specific surprise. In plain English, beta is the part explained by the market; the error term is the stock doing its own weird thing.
2. If you plotted a stock’s returns against market returns and drew the best-fit line, the slope of that line is beta. Steeper line = more market sensitivity.
3. Practical takeaway: do not confuse total risk with priced risk. A stock can be a circus on its own and still not deserve a higher expected return unless that risk is market-related.
4. Exam hammer: investors should diversify away nonsystematic risk and demand compensation only for systematic risk, which beta is trying to measure.