Fundamentals of Institutional Asset Management

The following sections are included:

• Dedication
• Preface
• About the Authors
• Acknowledgments
• Contents

Asset management is the process of managing the funds of clients. Other terms commonly used to describe this process are investment management, portfolio management, and money management. Accordingly, the individual who manages a portfolio of investments is referred to as an asset manager, investment manager, portfolio manager, or money manager. We will use these terms interchangeably throughout this book. In industry jargon, an asset manager “runs money”. The 10 largest asset management firms in the world based on assets under management (AUM) in U.S. dollars as of the first quarter of 2019 are (1) BlackRock ($6.84 trillion AUM), (2) The Vanguard Group ($5.6 trillion AUM), (3) Charles Schwab ($3.7 trillion), (4) JPMorgan Chase ($1.9 trillion AUM), (5) State Street Global Advisors ($3.12 trillion AUM), (6) Fidelity ($3.0 trillion AUM), (7) Allianz Global Investors ($2.5 trillion AUM), (8) PIMCO ($1.9 trillion AUM), (9) BNY Mellon ($1.9 trillion AUM), and (10) Amundi ($1.71 trillion AUM) Lemke [2019]. The largest 20 asset management firms in the world have a combined AUM of $44.9 trillion. Of the top 20, 12 are headquartered in the United States, three in France, two in Switzerland, and two in Germany (Fischer [2019])…

Throughout this book, we will use the word “risk”. An Internet search on the word “risk” shows results in excess of 42 million. With respect to investments, clients typically view risk as the potential that there will be a negative outcome relative to what was expected. As we will see, that is too general a definition of risk. Here, we will explain the various types of investment risk which will be discussed further in later chapters.

To raise funds for operating a business, a corporation issues various financial instruments. They can be either an equity security or a debt instrument. An equity security represents an ownership interest in a corporation. In contrast to an equity security, a debt instrument is a debt obligation of the issuing corporation and is the subject of the next chapter. Equity securities entitle the holder of the security to the earnings of the corporation when those earnings are distributed in the form of dividends. Should a corporation be liquidated, an investor is entitled to a pro rata share of the corporation’s remaining equity…

In its simplest form, a debt instrument is the financial obligation of an entity that promises to pay a specified sum of money at specified future dates. The payments are made up of two components: (1) the repayment of the amount of money borrowed and (2) interest. The entity that promises to make the payment is called the issuer of the security or the borrower. Debt instruments include bonds and bank loans.

In Chapters 3 and 4, we discussed equities and debt instruments. In this chapter, we cover collective investment vehicles and alternative assets. Collective investment vehicles involve the pooling of funds by investors and then the investment of those funds in certain assets and asset classes. Three major advantages of the indirect ownership of securities by investing in collective investment vehicles are the risk reduction through diversification, professional management of assets, and possible favorable tax treatment…

Derivative instruments, or simply derivatives, are contracts that essentially derive their value from the behavior of cash market instruments such as stocks, stock indexes, bonds, currencies, and commodities that underlie the contract. There are three general categories of derivatives: (1) futures and forwards, (2) options, and (3) swaps. Derivatives are either traded on an exchange or in the over-the-counter (OTC) market. That is, there are exchange-traded derivatives and OTC derivatives. Exchange-traded derivatives are standardized contracts. An advantage of OTC derivatives over exchange-traded derivatives is that they offer asset managers customized solutions for their investment strategy. In fact, one of the keys to the success of OTC derivatives is the flexibility of the payoff structures that can be created. A key difference between exchange-traded and OTC derivatives is that the former are guaranteed by the exchange, while the latter are the obligation of the non-exchange entity that is the counterparty. Thus, the user of an OTC derivative is subject to credit risk or counterparty risk…

In evaluating performance of an asset manager, an investment strategy, or an investment vehicle, the first step is to calculate the actual return realized. Several methodologies for computing the actual return are explained in this chapter. Performance evaluation must take into account the risks associated with any investment. Although we described the various types of risks in Chapter 2, in this chapter we will explain and illustrate several measures to quantify risk. A more detailed discussion of how these risk measures are calculated is provided in Chapter 8 of the companion book. Reward-risk ratios combine return (or reward) from an investment relative to its risk. Four reward-risk ratios are described at the end of this chapter.

In this chapter, we will explain a theory about how investors should construct a portfolio. The model for portfolio construction was developed in 1952 by Harry Markowitz and, despite being developed almost 70 years ago, is still referred to as modern portfolio theory. Because this theory for portfolio construction uses as inputs the mean and variance of portfolio returns, the theory is commonly referred to as mean-variance analysis. This framework for portfolio construction is one of the two principal theories in asset management. Prior to the development of mean-variance analysis, asset managers would often speak of risk and return but failed to quantify these important measures and apply them in portfolio construction. Moreover, asset managers would focus on the risks of individual assets without understanding how combining those into a portfolio could affect a portfolio’s risk. In the next chapter, an economic theory called the capital asset pricing model is explained and is the second principal theory in asset management. This theory, which provides the relationship between risk and expected return, is used to determine how assets should be priced in the market. It does so by estimating what return market participants should expect for an asset given its risk and how risk should in fact be measured…

Asset pricing models, the subject of this chapter, describe the relationship between risk and expected return. When we refer to asset pricing models in this chapter, we mean the expected return investors require given the risk associated with an investment. The most well-known equilibrium pricing models are the capital asset pricing model (CAPM) developed in the 1960s and its subsequent extensions. We also describe the arbitrage pricing theory (APT), an asset pricing model developed in the mid-1970s.

Company analysis involves the selection, evaluation, and interpretation of economic and financial data and other pertinent information to assist in evaluating the operating performance and financial condition of a company. The information that is available for analysis includes economic, market, and financial information. For publicly traded companies, much of the most important financial data are provided by the company in its annual and quarterly financial statements…

In this chapter, we discuss popular methods for valuing a firm’s equity or the value of a share of common stock. These methods fall into two categories: discounted cash flow model method and valuation by multiples method. Both methods require strong assumptions and expectations about the future. The product of these models is an estimate of the fair value of a stock. All fair value estimates are subject to model error and estimation error. There is no single valuation model that is perfect…

Common stock investment strategies are classified as either beta strategies or alpha strategies. As explained in Chapter 7, the beta of a portfolio or an investment strategy is a measure of the volatility of the portfolio or investment strategy relative to the benchmark. For example, if the benchmark is the Standard & Poor’s 500 and the beta of a portfolio is equal to 1, this means that the portfolio will move with the market. So, if the S&P 500 changes in 1 year by 6%, the portfolio is expected to change by approximately 6%. Investors who either manage their own portfolio to match the performance of the benchmark or who engage an asset manager to do so, are referred to as passive investors and the strategies that they follow are referred to as beta strategies. In contrast, investors who pursue a strategy to outperform a benchmark or who engage an asset manager to do so are referred to as active investors and the strategies pursued are referred to as alpha strategies. In this chapter, we focus on beta strategies, and in the next chapter, we focus on alpha strategies.

As explained in Chapter 12, strategies employed by equity portfolio managers are either indexing-type strategies or active strategies. The selection of the type of strategy to pursue depends on a client’s view of the pricing efficiency of the stock market. Indexing-type strategies, referred to as beta strategies and the subject of Chapter 12, should be pursued when clients believe that asset managers cannot outperform the stock market after adjusting for risk, transactions costs, and management fees. When a client holds the view that there are equity portfolio managers capable of outperforming the market, then they will seek to retain a manager who pursues an active strategy. Active strategies are called alpha strategies and are the subject of this chapter.

In Chapter 6, we reviewed the four types of derivatives — futures/forwards, swaps, options, and caps/floors — and the fundamental features of derivative instruments. We did not focus on any specific underlying or on how they are utilized by asset managers. When the underlying for a derivative is a common stock or some common stock index, the derivative is referred to as an equity derivative. In this chapter, we describe the different types of equity derivatives (stock index futures, equity swaps, and listed options on stocks and stock indexes) and derivatives that can be used to obtain exposure to market volatility. We then illustrate how they are used in managing a common stock portfolio.

In Chapter 4, we described the fundamental characteristics of debt instruments and the wide range of such investment vehicles available in the market. In this chapter and the one to follow, we discuss the analytics used to evaluate bonds and assess their potential performance. Although we focus on bonds, the bond analytics described here apply equally to other debt instruments. There are special considerations in the case of residential mortgage-backed securities…

The previous chapter was the first of two chapters on bond analytics. In the previous chapter, the pricing of debt instruments and the various yield measures were explained. In this chapter, we describe bond analytics that address interest rate risk analytics and credit risk analytics.

In this chapter, bond portfolio strategies are discussed, drawing on the portfolio analytics described in Chapters 15 and 16. We begin with the spectrum of strategies.

For many portfolio strategies, derivative instruments provide a more efficient vehicle for obtaining the objective sought by the asset manager. We explained how this is done for equity strategies in Chapter 14. In this chapter, we explain how interest rate derivatives — futures, options, swaps — and credit derivatives can be used in bond portfolio management.

At one time, a popular strategy for achieving diversification was a balanced fund strategy with the objective of income and capital appreciation. This strategy, offered to investors in the form of a mutual fund, invests in US equities and US bonds. The key in a balanced fund strategy — also referred to as a hybrid fund strategy and an allocation fund strategy — is the allocation among these two asset classes. In this strategy, the fund manager has a target allocation, the “stock/bond mix”. Morningstar classifies balanced funds into five categories according to a fund’s percentage of equities: (1) 15% to 30%, (2) 30% to 50%, (3) 50% to 70%, (4) 70% to 85%, and (5) 85%+…

The following sections are included:

• Author Index
• Subject Index