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Preface xxi

Acknowledgments xxiii

About the CFA Institute Investment Series xxv

Chapter 1 Professionalism in the Investment Industry 1

Learning Outcomes 1

1. Introduction 1

2. Professions 2

2.1. How Professions Establish Trust 2

2.2. Professions Are Evolving 4

3. Professionalism in Investment Management 5

3.1. Trust in the Investment Industry 6

3.2. CFA Institute as an Investment Professional Body 6

4. Expectations of Investment Professionals 7

5. Framework for Ethical Decision-Making 9

5.1. Description of the Framework 9

6. Challenges for Investment Professionals 11

7. Summary 12

References 13

Practice Problems 13

Chapter 2 Fintech in Investment Management 15

Learning Outcomes 15

1. Introduction 15

2. What is Fintech? 16

3. Big Data 17

3.1. Sources of Big Data 18

3.2. Big Data Challenges 20

4. Advanced Analytical Tools: Artificial Intelligence and Machine Learning 20

4.1. Types of Machine Learning 22

5. Data Science: Extracting Information from Big Data 23

5.1. Data Processing Methods 23

5.2. Data Visualization 24

6. Selected Applications of Fintech to Investment Management 25

6.1. Text Analytics and Natural Language Processing 26

6.2. Robo-Advisory Services 27

6.3. Risk Analysis 29

6.4. Algorithmic Trading 30

7. Distributed Ledger Technology 30

7.1. Permissioned and Permissionless Networks 32

7.2. Applications of Distributed Ledger Technology to Investment Management 32

Summary 34

Practice Problems 35

Chapter 3 Capital Market Expectations, Part 1: Framework and Macro Considerations 37

Learning Outcomes 37

1. Introduction 38

2. Framework and Challenges 38

2.1. A Framework for Developing Capital Market Expectations 39

2.2. Challenges in Forecasting 42

3. Economic and Market Analysis 50

3.1. The Role of Economic Analysis 51

3.2. Analysis of Economic Growth 51

3.3. Approaches to Economic Forecasting 57

3.4. Business Cycle Analysis 61

3.5. Analysis of Monetary and Fiscal Policy 68

3.6. International Interactions 77

4. Summary 81

References 85

Practice Problems 85

Chapter 4 Capital Market Expectations, Part 2: Forecasting Asset Class Returns 93

Learning Outcomes 93

1. Introduction 94

2. Overview of Tools and Approaches 94

2.1. The Nature of the Problem 94

2.2. Approaches to Forecasting 95

3. Forecasting Fixed-Income Returns 96

3.1. Applying DCF to Fixed Income 96

3.2. The Building Block Approach to Fixed-Income Returns 98

3.3. Risks in Emerging Market Bonds 104

4. Forecasting Equity Returns 107

4.1. Historical Statistics Approach to Equity Returns 107

4.2. DCF Approach to Equity Returns 107

4.3. Risk Premium Approaches to Equity Returns 111

4.4. Risks in Emerging Market Equities 115

5. Forecasting Real Estate Returns 117

5.1. Historical Real Estate Returns 117

5.2. Real Estate Cycles 117

5.3. Capitalization Rates 118

5.4. The Risk Premium Perspective on Real Estate Expected Return 120

5.5. Real Estate in Equilibrium 120

5.6. Public vs. Private Real Estate 121

5.7. Long-Term Housing Returns 122

6. Forecasting Exchange Rates 124

6.1. Focus on Goods and Services, Trade, and the Current Account 125

6.2. Focus on Capital Flows 127

7. Forecasting Volatility 132

7.1. Estimating a Constant VCV Matrix with Sample Statistics 132

7.2. VCV Matrices from Multi-Factor Models 133

7.3. Shrinkage Estimation of VCV Matrices 134

7.4. Estimating Volatility from Smoothed Returns 135

7.5. Time-Varying Volatility: ARCH Models 136

8. Adjusting a Global Portfolio 137

8.1. Macro-Based Recommendations 138

8.2. Quantifying the Views 140

Summary 141

References 143

Practice Problems 145

Chapter 5 Overview of Asset Allocation 155

Learning Outcomes 155

1. Introduction 155

2. Asset Allocation: Importance in Investment Management 157

3. The Investment Governance Background to Asset Allocation 158

3.1. Governance Structures 158

3.2. Articulating Investment Objectives 159

3.3. Allocation of Rights and Responsibilities 160

3.4. Investment Policy Statement 162

3.5. Asset Allocation and Rebalancing Policy 162

3.6. Reporting Framework 163

3.7. The Governance Audit 163

4. The Economic Balance Sheet and Asset Allocation 165

5. Approaches to Asset Allocation 169

5.1. Relevant Objectives 171

5.2. Relevant Risk Concepts 172

5.3. Modeling Asset Class Risk 173

6. Strategic Asset Allocation 180

6.1. Asset Only 182

6.2. Liability Relative 188

6.3. Goals Based 191

7. Implementation Choices 195

7.1. Passive/Active Management of Asset Class Weights 196

7.2. Passive/Active Management of Allocations to Asset Classes 196

7.3. Risk Budgeting Perspectives in Asset Allocation and Implementation 200

8. Rebalancing: Strategic Considerations 201

8.1. A Framework for Rebalancing 203

8.2. Strategic Considerations in Rebalancing 204

9. Summary 206

References 207

Practice Problems 209

Chapter 6 Principles of Asset Allocation 211

Learning Outcomes 211

1. Introduction 212

2. Developing Asset Only Asset Allocations 213

2.1. Mean-Variance Optimization: Overview 213

2.2. Monte Carlo Simulation 225

2.3. Criticisms of Mean-Variance Optimization 228

2.4. Addressing the Criticisms of Mean-Variance Optimization 230

2.5. Allocating to Less Liquid Asset Classes 241

2.6. Risk Budgeting 243

2.7. Factor-Based Asset Allocation 246

3.1. Characterizing the Liabilities 250

3.2. Approaches to Liability-Relative Asset Allocation 253

3.3. Examining the Robustness of Asset Allocation Alternatives 264

3.4. Factor Modeling in Liability-Relative Approaches 266

4. Developing Goals-Based Asset Allocations 266

4.1. The Goals-Based Asset Allocation Process 268

4.2. Describing Client Goals 270

4.3. Constructing Sub-Portfolios 272

4.4. The Overall Portfolio 276

4.5. Revisiting the Module Process in Detail 277

4.6. Periodically Revisiting the Overall Asset Allocation 281

4.7. Issues Related to Goals-Based Asset Allocation 281

5. Heuristics and Other Approaches to Asset Allocation 283

5.1. The "120 minus your age" rule. 283

5.2. The 60/40 stock/bond heuristic. 284

5.3. The endowment model. 285

5.4. Risk parity. 286

5.5. The 1/N rule. 288

6. Portfolio Rebalancing in Practice 288

7. Conclusions 292

References 294

Practice Problems 296

Chapter 7 Asset Allocation with Real-World Constraints 307

Learning Outcomes 307

1. Introduction 307

2. Constraints in Asset Allocation 308

2.1. Asset Size 308

2.2. Liquidity 314

2.3. Time Horizon 317

2.4. Regulatory and Other External Constraints 321

3. Asset Allocation for the Taxable Investor 327

3.1. After-Tax Portfolio Optimization 321

3.2. Taxes and Portfolio Rebalancing 331

3.3. Strategies to Reduce Tax Impact 332

4. Revising the Strategic Asset Allocation 337

4.1. Goals 337

5. Short-Term Shifts in Asset Allocation 343

5.1. Discretionary TAA 344

5.2. Systematic TAA 345

6. Dealing with Behavioral Biases in Asset Allocation 349

6.1. Loss Aversion 349

6.2. Illusion of Control 350

6.3. Mental Accounting 351

6.4. Representativeness Bias 352

6.5. Framing Bias 352

6.6. Availability Bias 354

7. Summary 357

References 359

Practice Problems 360

Chapter 8 Currency Management: An Introduction 369

Learning Outcomes 369

1. Introduction 369

2. Review of Foreign Exchange Concepts 370

2.1. Spot Markets 371

2.2. Forward Markets 373

2.3. FX Swap Markets 376

2.4. Currency Options 377

3. Currency Risk and Portfolio Return and Risk 377

3.1. Return Decomposition 378

3.2. Volatility Decomposition 380

4. Currency Management: Strategic Decisions 383

4.1. The Investment Policy Statement 384

4.2. The Portfolio Optimization Problem 385

4.3. Choice of Currency Exposures 386

4.4. Locating the Portfolio Along the Currency Risk Spectrum 389

4.5. Formulating a Client-Appropriate Currency Management Program 393

5. Currency Management: Tactical Decisions 395

5.1. Active Currency Management Based on Economic Fundamentals 396

5.2. Active Currency Management Based on Technical Analysis 397

5.3. Active Currency Management Based on the Carry Trade 399

5.4. Active Currency Management Based on Volatility Trading 401

6. Tools of Currency Management 406

6.1. Forward Contracts 407

6.2. Currency Options 414

6.3. Strategies to Reduce Hedging Costs and Modify a Portfolio's Risk Profile 416

6.4. Hedging Multiple Foreign Currencies 424

6.5. Basic Intuitions for Using Currency Management Tools 431

7. Currency Management for Emerging Market Currencies 435

7.1. Special Considerations in Managing Emerging Market Currency Exposures 435

7.2. Non-Deliverable Forwards 437

8. Summary 438

References 441

Practice Problems 441

Chapter 9 Overview of...