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© CANADIAN SECURITIES INSTITUTE (2019)

 PORTFOLIO MANAGEMENT
TECHNIQUES

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Copyright © 2019 by Canadian Securities Institute

PORTFOLIO MANAGEMENT TECHNIQUES

Content Overview

1 Portfolio Management: Overview

2 Ethics and Portfolio Management
3 The Institutional Investor
4 The Investment Management Firm
5 The Front Office
6 The Middle and Back Offices
7 Managing Equity Portfolios
8 Managing Fixed Income Portfolios
9 The Permitted Uses of Derivatives by Mutual Funds
10 Creating New Portfolio Management Mandates
11 Alternative Investments
12 Client Portfolio Reporting and Performance Attribution

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Table of Contents

1 Portfolio Management: Overview

1•3 INTRODUCTION

1•3 WHAT IS A PORTFOLIO MANAGER?

1•4 REGISTRATION CATEGORIES UNDER NATIONAL INSTRUMENT (NI) 31-103

1•4 Dealer Categories
1•5 Advisor Categories
1•5 Individual Categories
1•7 INVESTMENT INDUSTRY REGULATIONS
1•7 IIROC-Managed Account Requirements
1•8 The Canadian Securities Administrators (CSA)
1 • 13 Financial Transactions and Reports Analysis Centre of Canada (FINTRAC)
1 • 14 BEST PRACTICES

1 • 15 DISCRETIONARY MANAGEMENT WITHIN AN IIROC DEALER MEMBER

1 • 17 SUMMARY

2 Ethics and Portfolio Management

2•3 INTRODUCTION

2•3 ETHICS
2•3 What is Meant by Ethics?
2•4 What Are Values?
2•5 Ethical Dilemmas
2•7 CODE OF ETHICS
2•7 Strengths and Weaknesses
2•8 Best Practices
2•9 TRUST AND FIDUCIARY DUTY
2•9 Trust

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iv PORTFOLIO MANAGEMENT TECHNIQUES

2 • 11 Fiduciary Duty
2 • 14 SUMMARY

2 • 15 APPENDIX
2 • 15 Canadian Securities Industry – Standards of Conduct (Summarized; For Information Only)

3 The Institutional Investor

3•3 INTRODUCTION

3•3 FINANCIAL INTERMEDIATION

3•4 Institutional Investors
3•9 Other Industry Participants
3 • 10 Principal-Agent Relationships in Investment Management
3 • 12 GOVERNANCE
3 • 12 Regulatory Environment
3 • 13 Institutional Investment Fund Governance
3 • 16 SUMMARY

4 The Investment Management Firm

4•3 INTRODUCTION

4•3 OWNERSHIP AND COMPENSATION STRUCTURES

4•4 Privately Owned Structure
4•5 Publicly Owned Structure
4•6 Compensation Structures
4•8 REGULATIONS AND LICENSING
4•8 Individual Registrants versus Corporate Registrants
4•9 ORGANIZATIONAL STRUCTURE
4 • 10 Front, Middle and Back Offices
4 • 12 Ultimate Designated Person and Chief Compliance Officer
4 • 12 INVESTOR TYPES
4 • 13 Non-exempt Investors
4 • 13 Exempt Investors
4 • 14 Investor-Firm Interaction

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4 • 15 SERVICE CHANNELS
4 • 16 Pooled Funds
4 • 16 Segregated/Managed Accounts
4 • 17 Limited Partnerships
4 • 17 Sub-Advisory Capacity
4 • 17 INVESTMENT MANDATES
4 • 17 Domestic Single-Sector Mandates and Balanced Funds
4 • 18 Specialty- or Sector-Focused Mandates
4 • 19 Style-Focused Mandates
4 • 20 Passive Investment Management
4 • 20 Alternative Investments
4 • 21 Global Mandates
4 • 21 Offshore Investments
4 • 22 ROLES AND RESPONSIBILITIES OF INSTITUTIONAL INVESTMENT MANAGERS
4 • 22 Advisory versus Sub-advisory Relationship
4 • 23 Management Structure of Canadian Mutual Funds
4 • 26 Portfolio Manager’s Roles and Responsibilities as a General Partner
4 • 26 INVESTMENT MANAGEMENT FEES
4 • 28 Performance-Related Fees
4 • 29 INDUSTRY CHALLENGES
4 • 30 Investment Performance
4 • 30 Access to Suitable Distribution
4 • 31 Increased Compliance Requirements
4 • 32 Increasing Competition
4 • 33 Human Resources
4 • 33 Growth of Passive Investment Mandates
4 • 34 CORPORATE GOVERNANCE
4 • 34 Aspects of Good Corporate Governance
4 • 34 Potential Benefits of Good Corporate Governance
4 • 36 SUMMARY

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5 The Front Office

5•3 INTRODUCTION

5•3 AN OVERVIEW OF THE FRONT OFFICE

5•4 THE FOUR AREAS OF THE FRONT OFFICE

5•4 Portfolio Management
5•7 Trade Execution
5•8 Sales and Marketing
5•9 Client Service
5 • 10 INFORMATION FLOW AMONG FRONT OFFICE STAFF

5 • 12 FRONT OFFICE BEST PRACTICES

5 • 12 Performance Measurement
5 • 12 Dual Signatures
5 • 13 Employee Personal Trading
5 • 13 Investment Management Agreement
5 • 15 GETTING CLIENTS
5 • 15 Institutional and Mutual Fund Sponsors
5 • 18 Individual Investors
5 • 18 Timeline for Getting Clients
5 • 19 LOSING CLIENTS
5 • 19 Weak Investment Performance
5 • 20 Poor Client Service
5 • 20 Termination Process
5 • 21 SUMMARY

6 The Middle and Back Offices

6•3 INTRODUCTION

6•3 OVERVIEW OF THE MIDDLE OFFICE

6•4 THE MIDDLE OFFICE

6•4 The Compliance Function
6•8 The Legal Function
6•9 The Auditing Function

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6 • 10 The Accounting Function

6 • 11 The Middle Office’s Key Operational Interfaces and Information Flow
6 • 13 Middle Office Best Practices
6 • 14 THE BACK OFFICE
6 • 15 The Back Office’s Key Operational Interfaces and Information Flow
6 • 15 Back Office Best Practices
6 • 16 SUMMARY

7 Managing Equity Portfolios

7•3 INTRODUCTION

7•3 BOTTOM-UP AND TOP-DOWN APPROACHES

7•3 The Bottom-up Approach
7•6 The Top-Down Approach
7•6 PORTFOLIO MANAGEMENT STYLES
7•6 Passive Management Styles
7 • 13 Active Management Styles
7 • 16 Active Portfolio Construction
7 • 25 Comparing Passive and Active Portfolio Construction Techniques
7 • 27 THE USE OF DERIVATIVES IN EQUITY PORTFOLIO MANAGEMENT
7 • 27 Hedging a Portfolio with Equity Index Derivatives
7 • 29 Changing a Portfolio’s Asset Mix
7 • 31 TAX CONSIDERATIONS

7 • 31 THE USE OF EXCHANGE-TRADED FUNDS (ETFS) IN EQUITY PORTFOLIO MANAGEMENT

7 • 32 Definition of ETFs
7 • 33 Key Features
7 • 34 Analysis of the Choices to ETFs
7 • 35 Portfolio Management Techniques using Equity ETFs
7 • 38 Considerations when Investing in ETFs
7 • 39 Expanding Choices with ETFs
7 • 40 SUMMARY

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8 Managing Fixed Income Portfolios

8•3 INTRODUCTION

8•3 FIXED INCOME TRADING OPERATIONS

8•3 Roles and Responsibilities
8•4 Fixed Income Department – Functional Organization
8•5 Bond Financing and Repo Transactions
8•6 Comparison of Sell-Side and Buy-Side Fixed Income Professionals
8•8 BOND MANAGEMENT STYLES
8•8 Interest Rate Sensitivity
8 • 10 Macaulay Duration
8 • 14 Passive Portfolio Management
8 • 18 Active Portfolio Management
8 • 19 BOX TRADES
8 • 19 Bond Swaps
8 • 22 Dual Bond Swap (Box Trade)
8 • 25 OTHER BOND PORTFOLIO CONSTRUCTION TECHNIQUES
8 • 26 Asset-Backed Securities
8 • 28 Mortgage-Backed Securities
8 • 34 Other Fixed Income Securities
8 • 35 Using Derivatives in Fixed Income Management
8 • 43 Advantages and Disadvantages of Securitization
8 • 44 HIGH YIELD (JUNK) BONDS
8 • 44 High Yield Bond Issuers
8 • 45 High Yield Bond Investors
8 • 45 High-Yield Bond Market Indexes
8 • 46 Credit Rating Methodology
8 • 48 Default Risk and Default Rates
8 • 49 Unique Coupon Structures
8 • 50 FIXED INCOME EXCHANGE-TRADED FUNDS (ETFs)
8 • 51 Investment Mandates for Fixed Income ETFs
8 • 52 Investment Management Techniques for Fixed Income ETFs
8 • 54 SUMMARY

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9 The Permitted Uses of Derivatives by Mutual Funds

9•3 INTRODUCTION

9•3 THE TYPES OF MUTUAL FUNDS THAT USE DERIVATIVES

9•3 MUTUAL FUND REGULATIONS

9•4 Transactions for Hedging Purposes
9•5 Transactions for Non-Hedging Purposes
9•6 HOW MUTUAL FUNDS USE DERIVATIVES
9•6 Hedging Uses
9•6 Non-Hedging Uses
9•9 THE ADVANTAGES OF DERIVATIVES

9 • 10 THE POTENTIAL RISKS OF DERIVATIVES

9 • 13 SUMMARY

10 Creating New Portfolio Management Mandates

10 • 3 INTRODUCTION

10 • 3 NEW INVESTMENT PRODUCT DEVELOPMENT PROCESS

10 • 4 Step One: Identifying Potential Market Opportunities
10 • 5 Step Two: Determining the Required Portfolio Management Skills
10 • 7 Step Three: Assessing the Market
10 • 9 Step Four: Determining the Legal and Regulatory Restrictions
10 • 10 Step Five: Developing a Marketing and Distribution Strategy
10 • 11 Step Six: Preparing a Financial Forecast
10 • 14 Step Seven: Obtaining Approval from the Investment Management Firm’s New Product
Development Committee
10 • 15 Step Eight: Developing Project Management Timelines
10 • 17 Step Nine: Launching the Product
10 • 19 INVESTMENT GUIDELINES AND RESTRICTIONS
10 • 20 Common Design Factors for Investment Guidelines and Restrictions
10 • 23 Unique Factors in Equity Mandate Design
10 • 25 Unique Factors in Fixed Income Mandate Design
10 • 26 Unique Factors in Balanced Fund Mandates
10 • 28 SUMMARY

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11 Alternative Investments
11 • 3 INTRODUCTION

11 • 3 DEFINITION OF ALTERNATIVE INVESTMENTS

11 • 4 Hedge Funds
11 • 10 Commodities
11 • 10 Managed Futures Funds
11 • 11 Private Equity
11 • 12 Real Estate
11 • 14 REASONS TO INVEST IN ALTERNATIVE INVESTMENTS

11 • 16 ISSUES AND CHALLENGES WITH ALTERNATIVE INVESTMENTS

11 • 16 Asset Allocation Process
11 • 17 Security Pricing and Valuation
11 • 17 Short Sales
11 • 18 Accounting for Leverage
11 • 18 PERFORMANCE ATTRIBUTION
11 • 19 Lack of Suitable Performance Benchmarks
11 • 19 Lack of Mandate Definition and Standardization
11 • 19 Lack of Investment Strategy Transparency
11 • 20 THE UNIQUE RISKS OF ALTERNATIVE INVESTMENTS

11 • 24 DUE DILIGENCE
11 • 25 Assessing an Alternative Investment Fund’s Risk Profile
11 • 26 CURRENT TRENDS AND DEVELOPMENTS IN ALTERNATIVE INVESTING
11 • 26 Increased Government Regulation
11 • 26 Institutionalization
11 • 27 Continued Innovation
11 • 28 SUMMARY

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 TABLE OF CONTENTS xi

12 Client Portfolio Reporting and Performance Attribution

12 • 3 INTRODUCTION

12 • 3 CLIENT PORTFOLIO REPORTING

12 • 3 Global Investment Performance Standards
12 • 3 Key Aspects of the GIPS Standards
12 • 5 PORTFOLIO MANAGEMENT REPORTS
12 • 6 Book versus Market Prices
12 • 7 Comparing Portfolio Manager and Custodian Reports
12 • 10 PERFORMANCE ATTRIBUTION
12 • 11 An Example of Performance Attribution Analysis
12 • 13 Sector Attribution
12 • 16 Performance Attribution Styles
12 • 18 SUMMARY

G Glossary

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 Portfolio Management:
Overview 1

CONTENT AREAS

What is a Portfolio Manager?

Registration Categories Under National Instrument (NI) 31-103

Investment Industry Regulations

Best Practices

Discretionary Management Within an IIROC Dealer Member

LEARNING OBJECTIVES

1 | Describe what a portfolio manager is.

2 | Identify and explain the various dealer, advisor and individual registration categories available in
Canada.

3 | Describe the regulatory environment in Canada.

4 | Identify IIROC-managed account rules with respect to the documentation required and the account
approval and oversight process.

5 | Outline the various investment practices the Canadian Securities Administrators (CSA) regulates.

6 | Explain the compliance requirements of the Financial Transactions and Reports Analysis Centre of
Canada (FINTRAC).

7 | Outline some of the investment management industry’s best practices.

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1•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

advisors market timing

Canadian Securities Administrators (CSA) National instruments

dealers Personal Information Protection and Electronic

Documents Act (PIPEDA)
fairness policy
portfolio manager
Financial Transactions and Reports Analysis
Centre of Canada (FINTRAC) provincial and territorial securities
commissions
high closing
self-regulatory organizations (SROs)
Know Your Client (KYC) rule
soft dollar arrangement
late trading

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 CHAPTER 1 | PORTFOLIO MANAGEMENT: OVERVIEW 1•3

INTRODUCTION
In the 1930s, Benjamin Graham and David Dodd published their seminal work on investing,1 suggesting that
securities could be valued according to relatively simple yet immensely powerful concepts, based on the idea that
some securities were inherently more attractive than others. These insights moved investing out of the realm of
outright speculation and into that of a profession. In the 1950s, investment became the subject of doctoral-level
research as Harry Markowitz, a graduate student at the University of Chicago, first developed the idea that became
known as modern portfolio theory (MPT),2 which numerous scholars have since expanded upon.
Decades ago, most individuals worked for one employer, or a small number of employers, over their working
lifetime. They expected to retire at the age of 65 with a secure company pension, bolstered, in Canada at least, by
government pension arrangements, such as the Canada Pension Plan (CPP) and the Québec Pension Plan (QPP),
which provided for a comfortable lifestyle in their retirement years. Nowadays, when it comes to company pension
plans, the trend is toward a defined contribution approach, rather than a defined benefit approach, where the
responsibility for investing for retirement has shifted from employers and governments to individuals.
At the same time, life expectancy for most Canadians has increased. This means that individuals must not only
plan for their own retirement, but also ensure their investments will sustain their lifestyle for a longer period of
retirement than ever before.
As a result, portfolio management — whether for individual clients, in the case of investment advisors, or for
institutional investors, such as mutual funds or insurance companies — is a growing area in the financial services
industry.
Not just anyone can decide to be a portfolio manager; first, there are credentials to acquire and specific educational
and licensing requirements to meet. This chapter will describe the basics of the industry, including how to become a
portfolio manager and what the role involves, as well as some of the basic regulatory requirements of the portfolio
management business.

WHAT IS A PORTFOLIO MANAGER?

Apart from the legal and regulatory definition, which we will discuss later in this chapter, what is meant by the
term “portfolio manager”? Simply put, a portfolio manager is an individual, or a team of individuals, who advises
clients, which can be individuals or different types of institutional investors, on investments that are appropriate to
a client’s individual circumstances and investment objectives. A portfolio manager may make recommendations on
broad asset allocation decisions, such as the appropriate allocation to equities, bonds and cash, or they may make
specific recommendations on particular stocks or bonds, or do both.
From a regulatory perspective, a portfolio manager has the authority to make discretionary trades in securities
on behalf of clients. For anyone currently registered with the various securities commissions to act in a sales
capacity for securities or mutual funds, this authority is recognized as a special status. Securities regulators
require a specific set of qualifications in order for an individual to be registered as a portfolio manager. National
Instrument (NI) 31-1033 explains the education and experience required for individuals who wish to be registered
as a portfolio manager-advising representative (see the feature box “Overview of Required Educational Programs”
for a description of the course requirements for becoming a portfolio manager). In addition, an individual may be
registered as a portfolio manager-associate advising representative, which places them under the direct supervision
of a portfolio manager-advising representative.

1
Benjamin Graham and David Dodd, Security Analysis (New York: McGraw-Hill, 2004). First published by Whittlesey House, New York, in 1934.
2
Harry M. Markowitz, “Portfolio Selection,” The Journal of Finance 7, No. 1 (March 1952): 77–91.
3
National Instrument (NI) 31-103 can be found at https://www.bcsc.bc.ca/Securities_Law/Policies/Policy3/PDF/31-103__NI___June_12__2018/.

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1•4 PORTFOLIO MANAGEMENT TECHNIQUES

An individual that is a registered representative (RR) at an investment dealer may also be allowed to exercise
discretionary authority over a managed account if they meet the educational and experience requirements outlined
in IIROC Rule 2900.

Exhibit 1.1 | Overview of Required Educational Programs

• Chartered Financial Analyst (CFA)® Program

The CFA Program is offered exclusively by the CFA Institute, the issuing body for the CFA designation. The CFA
Program requires the completion of three six-hour exams and the accumulation of 48 months of approved work
experience. Topics of study include accounting, economics, equity analysis, fixed income analysis, derivatives,
real estate, statistics and ethics.

• Chartered Investment Manager (CIM)® Designation

The CIM designation is achieved through a program offered exclusively by the Canadian Securities Institute.
There are two ways to obtain the CIM designation, with the most popular requiring the completion of three
courses: the Canadian Securities Course (CSC)®, the Investment Management Techniques (IMT)® course and
the Portfolio Management Techniques (PMT)® course. A chief advantage of these courses is that the material
focuses on the marketplace, financial markets and regulatory environment in Canada.

REGISTRATION CATEGORIES UNDER NATIONAL INSTRUMENT (NI)

31-103
Firms in Ontario must be registered with the appropriate regulator, either the Ontario Securities Commission (OSC)
or an approved self-regulatory organization, namely the Investment Industry Regulatory Organization of Canada
(IIROC) or the Mutual Fund Dealers Association of Canada (MFDA). Firms can fall into several registration categories
under the two main categories of dealers and advisors.

DEALER CATEGORIES
A dealer is a person or company that is in the business of trading in securities in the capacity of a principal or agent.
Some of the relevant dealer categories include:

Investment dealer A dealer who engages in the business of trading in securities in the capacity of an
agent or principal, and is a dealer member of IIROC. An investment dealer also has the
authority to act as an underwriter.

Mutual fund dealer A dealer registered exclusively for the purpose of trading in shares or units of mutual
funds. Other than in Quebec, a mutual fund dealer must be a member of the MFDA.

Scholarship plan dealer A dealer who is restricted to scholarship plans, educational plans or educational trust
investments.

Exempt market dealer A dealer who trades or advises in the exempt market, such as private placements.

Restricted dealer An open category that will allow flexibility in registration.

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 CHAPTER 1 | PORTFOLIO MANAGEMENT: OVERVIEW 1•5

ADVISOR CATEGORIES
NI 31-103 enables the uniform registration of advisors in all provinces and territories. The registration categories are:

Portfolio manager A person or company that manages clients’ investment portfolios through the
discretionary authority granted by the clients.

Restricted portfolio A person or company that acts as an adviser regarding a security in accordance with the
manager terms, conditions, restrictions or requirements applied to its registration.

INDIVIDUAL CATEGORIES
The following are the registration groups for an individual who, under securities legislation, is required to be
registered to act on behalf of a registered firm:

Dealing representative An individual who may act as a dealer or an underwriter regarding a security that the
individual’s sponsoring firm is permitted to trade or underwrite.

Advising representative An individual who may act as an adviser regarding a security that the individual’s
sponsoring firm is permitted to advise on.

Associate advising An individual who may act as an adviser regarding a security that the individual’s
representative sponsoring firm is permitted to advise on if the advice has been pre-approved by an
individual that the sponsoring firm has designated.

Ultimate Designated An individual who must supervise the firm’s activities that are directed towards ensuring
Person compliance with securities legislation and each individual acting on the firm’s behalf. In
addition, they must promote the firm’s compliance, as well as the individuals acting on
its behalf, with securities legislation.

Chief compliance An individual who must, along with other requirements, establish and maintain policies
officer and procedures for assessing the firm’s compliance, as well as the individuals acting on
its behalf, with securities legislation. In addition, they must monitor and assess the firm’s
compliance, as well as the individuals acting on its behalf, with securities legislation.

Exhibit 1.2 | Educational and Experience Requirements for a Portfolio Manager

i. Portfolio Manager – Advising Representative:

a. The individual must have earned the CFA designation and have 12 months of relevant investment
management experience earned in the last 36 months prior to applying for registration; or
b. The individual must have earned the CIM designation and have 48 months of relevant investment
management experience, with 12 months of this relevant experience earned in the last 36 months prior to
applying for registration.
ii. Portfolio Manager – Associate Advising Representative:
a. The individual must have completed Level 1 of the CFA Program and have 24 months of relevant investment
management experience; or
b. The individual must have received the CIM designation and have 24 months of relevant investment
management experience.

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Exhibit 1.2 | Educational and Experience Requirements for a Portfolio Manager

iii. Portfolio Manager – Chief Compliance Officer:

a. The individual must have earned the CFA designation or a professional designation, such as a lawyer,
Chartered Accountant, Certified General Accountant or Certified Management Accountant in a jurisdiction in
Canada; a notary in Quebec; or the equivalent in a foreign jurisdiction.
The individual must have also successfully completed the Partners, Directors and Senior Officers (PDO)
course or the Chief Compliance Officers (CCO) qualifying exam, and, if they have not earned the CFA
designation, the Canadian Securities Course (CSC). The individual must have 36 months of relevant
securities experience at an investment dealer, a registered advisor or an investment fund manager, or have
provided professional services in the securities industry for 36 months. The individual must have also worked
at a registered dealer, a registered adviser or an investment fund manager for 12 months; or
b. The individual must have successfully completed the CSC and either the PDO or the CCO and have worked
at an investment dealer or a registered advisor for five years (including 36 months in a compliance capacity),
or the individual must have worked for five years at a Canadian financial institution in a compliance capacity
relating to portfolio management and worked at a registered dealer or registered adviser for 12 months; or
c. The individual must have successfully completed the PDO or the CCO and have met the requirements of a
portfolio manager-advising representative.
iv. For IIROC registrants: RR exercising discretionary authority over a managed account: outlined in IIROC Rule
2900 – Proficiency and Education.*

* IIROC Rule 2900 can be found at http://www.iiroc.ca/Rulebook/MemberRules/Rule02900_en.pdf.

DID YOU KNOW?

Managers, Portfolio Advisors and Sub-Advisors

In Canada, much confusion arises around the definitions of the terms manager, portfolio advisor and
sub-advisor.

In a regulatory sense, the manager is the sponsoring organization of a managed product such as a
mutual fund. A fund’s manager bears ultimate responsibility for its adherence to the various pertinent
regulations governing operations, including advertising, performance presentation, sales and
compliance.

The portfolio advisor is the entity engaged to provide actual portfolio management and advice services
to a fund’s manager. Of course, the management firm and the advisory firm may be one and the same,
or the portfolio advisor may be a division of the manager. Every fund must be managed in some sense,
and so the portfolio advisor must be disclosed in prospectus materials.

For several reasons, the advisor may hire the portfolio management and advice services of a third-party
firm, the sub-advisor. First, in-house portfolio management is expensive, requiring software systems for
record-keeping and portfolio accounting, infrastructure for a portfolio management team and salaries
for staff. A start-up operation or one with relatively low assets under management may find it more
economical to employ sub-advisors for portfolio management services. Second, an advisor may employ
a sub-advisor that has a different investment style from the portfolio manager, or one with a particular
skill in a sector-specific mandate that the advisor or manager cannot provide.

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INVESTMENT INDUSTRY REGULATIONS

The investment industry is one of the most regulated sectors of Canada’s economy. However, it should be
remembered that no amount of regulation will prevent outright fraud and criminality. At the same time, those in
the industry, particularly portfolio managers, should view regulation as a positive for the business.
Above all in their profession, portfolio managers are charged with the stewardship of their clients’ money.
Regulation is designed to protect investors not from their own imprudence, but from impropriety and a lack of
professionalism on the part of those entrusted with their assets. A firm’s senior leadership that exhibits a strong
commitment to the highest level of ethics and professionalism helps breed a culture of compliance throughout the
organization.
Canada is the only major industrialized nation without a national securities regulator. Securities regulations in
Canada fall under the jurisdiction of the various provincial and territorial securities commissions, which are
charged with enforcing and helping to frame the various securities acts of the provinces. Thus, at the highest level,
there are 13 primary regulators in Canada: 10 provincial and three territorial. This is in contrast to the U.S., where
the U.S. Securities and Exchange Commission is the national securities regulator.
The registration and regulation of portfolio managers remain the chief responsibility of the provincial securities
commissions. Portfolio management firms with multiple operations — for instance, portfolio management,
securities dealing, mutual fund dealing and securities trading — may well be faced with different primary regulators
for each activity or line of business. Portfolio managers should be familiar with the primary regulators for each of
their intended operations.
In many cases, the various securities commissions have delegated the regulation of the investment industry to
self-regulatory organizations (SROs), which are charged with monitoring the activities of their member firms. For
instance, the regulation of investment dealers has been largely delegated to IIROC. Mutual fund dealers are now
largely under the jurisdiction of the MFDA, which is recognized as an SRO in Alberta, British Columbia, Nova Scotia,
Saskatchewan, Ontario, New Brunswick, Prince Edward Island, and Manitoba, with an application for that status
pending in Newfoundland and Labrador.
Canada’s regulatory environment is under increasing scrutiny and pressure for reform, with many market
participants believing that overlapping regulations result in the duplication of effort, the squandering of time and
resources, and an increased overall cost of investing, which must ultimately be borne by investors. In a number of
areas, efforts have been made to streamline and coordinate securities regulations across the country.

IIROC-MANAGED ACCOUNT REQUIREMENTS

A managed account is “any account solicited4 by a dealer member or any partner, director, officer or registered
representative of a dealer member, in which the investment decisions are made on a continuing basis by the dealer
member or by a third party hired by the dealer member.” This means that discretionary authority has been given
on an ongoing basis, and is a permanent arrangement, rather than a temporary one. IIROC must approve dealer
members to handle managed accounts and ensure they are compliant with its rules.
No dealer member or any person acting on its behalf is permitted to exercise discretionary authority over
these accounts unless the Registered Representative has completed the proficiency requirements for portfolio
management and notice has been given to IIROC. IIROC will permit sub-advisors to manage these accounts
provided that there is a written sub-advisor agreement with the member in place, and the individual or dealer
member is registered to provide discretionary portfolio management services in the jurisdiction in which they
reside. The jurisdiction must have conflict of interest provisions that are at least equivalent to IIROC Rules, or the
sub-advisor must agree that it will comply with IIROC Rules.

4
A common definition of solicit is “to seek or invite”.

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In order for a dealer member to approve a managed account, a client must sign a managed account agreement, and
the dealer member’s designated supervisor for managed accounts must accept it. The managed account agreement
must also clearly indicate the client’s investment objectives for the account and they must be provided with a copy
of the member’s procedures to ensure the fair allocation of investment opportunities among managed accounts.
Without the client’s written consent, dealer members dealing with managed accounts are restricted from the
following:
• Investing in any securities, futures contract or option that is based on the securities of the dealer member or an
issuer related or connected to the dealer member;
• Investing in an issuer, futures contract or option that is based upon the securities of an issuer of which a
responsible person is an officer or director, unless such office or directorship has been disclosed to the client and
they have given written consent;
• Investing in a security that is being bought or sold from an account of a responsible person or an associate of a
responsible person to a managed account;
• Investing in new or secondary issues of securities that the member has underwritten; and
• Making a loan to a responsible person or their associate.

A responsible person is a partner, director, officer, employee or agent of a dealer member who exercises
discretionary authority over an account, or participates in the formation of or has prior access to information
regarding investment decisions to be made for a managed account.
The designated supervisor must review each managed account on a quarterly basis to ensure that a client’s
investment objectives are diligently pursued and that the managed account’s transactions are being conducted
in accordance with applicable rules. Reviews may be conducted on an aggregate basis, where decisions are made
centrally and applied across a number of accounts.
Both a client and dealer member may terminate managed account agreements, as long as the request is submitted
in writing. A client may terminate an agreement at any time, but if a dealer member is terminating it, the client
must be given at least 30 days’ notice.
Managed accounts of partners, directors, officers and employees, or agents of a dealer member are exempt from the
client priority rule where the account is centrally managed with other client accounts and the account participates
equally with client accounts when investment decisions are implemented.

THE CANADIAN SECURITIES ADMINISTRATORS (CSA)

Although there is no national securities regulator in Canada, the Canadian Securities Administrators (CSA) is a
working group of regulators from each provincial and territorial regulator that is charged with forging uniformity in
regulation, where possible. The CSA has issued a number of national instruments, a series of regulations applicable
across the country that serve to harmonize rules and regulations in each jurisdiction.
For example, National Instrument (NI) 81-102 is the framework for the mutual fund industry in Canada. NI 81-102
regulates many aspects of the mutual fund business — from rules on acceptable investments for mutual funds,
performance presentation and advertising, to rules on the use of derivatives and the degree of controlling share
ownership. Every portfolio manager who manages mutual fund portfolios, or who advises clients on investing in
mutual funds, needs to be very familiar with the rules of NI 81-102.5
The following sections outline some of the activities that the CSA regulates or bans.

5
The full text of NI 81-102 is available from a number of sources on the Internet, including this one from the British Columbia
Securities Commission: https://www.bcsc.bc.ca/Securities_Law/Policies/Policy8/PDF/81-102__NI___January_3__2019/.

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HIGH CLOSING
Essentially, high closing is entering a higher bid price for a security at closing to artificially increase the net asset
value (NAV) of the fund to which the security belongs. Securities exchanges operate on the basis of a bid-offer
spread. Mutual funds and other managed portfolios offer a daily pricing mechanism, whereby a fund’s market value
per share is established at the end of each business day. In order to do this, it is necessary to obtain a market price
for each security in the portfolio. This price is established at the end of an exchange’s trading day (4 p.m. Eastern
Standard Time in Toronto and New York).
Accounting rules mandate that a portfolio’s securities be valued at the bid price at the close of trading.

EXAMPLE
Suppose a security, which is held in a fund’s portfolio, has been quoted at a bid price of $10.00 and an offer of
$10.10 for the entire day, and has traded only at $10.00 during the day. The portfolio’s security would be valued
that evening at $10.00 per share. High closing involves the portfolio manager entering a bid price of $10.05
seconds before the close of trading, even though they have no intention of actually purchasing shares at that
price. In that case, the portfolio’s security would be valued at the bid price of $10.05, rather than $10.00, thus
artificially inflating the fund’s NAV.

WHY WOULD A MANAGER DO THIS?

In a highly competitive business, the difference between a first-quartile performance and a second-quartile
performance can be a matter of basis points. Since portfolio managers are typically evaluated and compensated
on the basis of relative performance, high closing artificially inflates the fund’s value, and thus potentially its
performance. Purchasers of the fund that evening would pay a higher price than warranted by the security’s
trading, while sellers would receive benefits they would not otherwise have enjoyed. In addition, because fund
managers are paid as a percentage of assets under management, by artificially boosting a fund’s reported NAV,
a manager would increase the fees that the fund would pay them or their firm, all to the detriment of unitholders.

Portfolio managers should be aware that, in addition to being unethical, high closing is illegal.

LATE TRADING
Managers of mutual funds and other managed products must provide pricing for their products so that investors
may purchase units or redeem them on a regular basis — in the case of mutual funds, usually on a daily basis. In
order to achieve this, firms must establish a cut-off time for the fund’s orders to be placed so that they can be
processed at that day’s NAV. Usually, but not always, that cut-off time is 4 p.m., to coincide with the close of
trading of a securities exchange.
The essence of trading in mutual fund units is that all traders are placing their orders “blind”; that is, they do not
know what price they will either purchase or sell at, only that they will trade at that day’s established price. Late
trading occurs when a mutual fund company allows a trader to enter an order, either to purchase or sell, after the
established cut-off time.

WHY WOULD A TRADER DO THIS?

A trader might want to do this because, with a reasonable idea of the securities held by a mutual fund, they
would have a reasonably good idea of what the day’s price might be for that mutual fund. The trader could then
place an order to buy knowing the fund would benefit from market action that day. Conversely, if the trader
knew of an event that would adversely affect a fund’s performance or price, they could enter an order to sell and
benefit at the expense of other investors, who would be placing their orders without foreknowledge of the fund’s
price.

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Late trading is decidedly illegal. Portfolio managers must make themselves familiar with the published rules around
late trading at their firms, and also be aware of their firms’ processes for placing orders.

MARKET TIMING
Market timing is another practice that emerged from a late-trading scandal. However, in contrast to late trading,
market timing is not illegal. The marketing literature of most mutual fund companies praises the virtues of long-
term investing and actively discourages investors from frequently trading units of their funds. Indeed, mutual funds
are intended as long-term investment vehicles, and frequent trading suggests the lack of either a solid long-term
financial plan or a clear understanding of the risks involved in financial markets.
Market timing generally involves large investors taking advantage of inefficiencies in the way mutual funds are
priced, notably international funds, where the portfolio’s securities must be priced daily, but the overseas markets
are closed hours ahead of North American ones. The growing correlation between global equity markets means that
a major event in the afternoon in North America will be reflected in market performance on the same day, but it will
not spill into Europe until the next day, simply due to differing time zones.

WHY WOULD A TRADER DO THIS?

Market timers have an incentive to sell their global funds today, knowing that negative developments in North
America will not appear in the price of their international funds until tomorrow. The reverse is also true; a market
timer could take advantage of salutary market news by buying the international funds today, knowing the
positive news will not have an impact on the fund until tomorrow.

In short, fund companies are required to actively discourage and deter market timing efforts. Prospectuses must
clearly state that the firm does not practice market timing. Short-term trading penalties must be strictly adhered
to if they are published, and fund companies must be prepared to refuse orders from clients who demonstrate a
pattern of market timing attempts.

CLIENT PRIVACY REQUIREMENTS

Portfolio managers are in a unique position because securities regulation requirements mean that portfolio
managers must gather all manner of highly sensitive and confidential financial information about their clients,
such as income, net worth, personal circumstances, bank accounts and the like. In addition, portfolio managers
must keep detailed records of transactions on behalf of their clients. Clearly, portfolio managers must be diligent in
protecting the security of that data from unauthorized access.
In Canada, the Personal Information Protection and Electronic Documents Act (PIPEDA) mandates the security
of all personal and private data. PIPEDA established 10 principles that businesses, including portfolio management
firms, must follow when collecting, using and disclosing private information about clients, as follows:
1. An organization must appoint a privacy officer who is accountable for maintaining the business’s compliance
with the principles.
2. A business must disclose the reason for collecting the information at the time it is collected.
3. The consent of the individual providing the information must be sought before it is collected, used or
disclosed.
4. The data collected must be limited to that which is necessary, and shall be collected by lawful and fair means.
5. The information collected must be used only for the stated purpose, and retained only as long as is necessary.
6. The information must be accurate and up to date for the purposes in which it is to be used.
7. The information must be protected in a manner consistent with its sensitivity.
8. A business must make its policies on the collection, use and disclosure of data available to its customers.

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9. Upon request, an individual must be informed of the existence of their personal information, its use and
disclosure, and have the opportunity to challenge its accuracy.
10. An individual must have the ability to challenge the business’s compliance with the requirements of PIPEDA.6

Portfolio managers must make clear to their clients the reasons for the collection of their information, and that they
will safeguard that information. An important point to remember is that many portfolio managers work for very
large organizations, such as banks, where sharing information between various departments within the organization
used to be commonplace. Now the managers must treat that information as inviolate and ensure that it is not
shared or disclosed, except with the client’s express consent, unless it would be appropriate to do so, as in the
reporting of suspicious activity to the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC), as
will be discussed later.

TRADING SECURITIES ON THE INTERNET

The Internet has changed the way we live and work. One of its chief benefits is that the globe seems a much smaller
place because a web page is accessible from anywhere in the world. In the investment industry, the Internet has
been used to distribute securities. Obviously, regulating Internet trades is much more difficult than regulating other
types of trading. National Policy (NP) 47-201 (Trading Securities Using the Internet and Other Electronic Means) is the
response of Canada’s regulators to dealing with the distribution of securities via the Internet.7
NP 47-201 states that an offering of securities that is accessible to Canadian investors is subject to Canadian
disclosure rules, including prospectus requirements, unless the distribution prominently and clearly states that
the offering is not available to Canadian investors. Otherwise, anyone distributing securities via the Internet is
considered subject to Canadian rules.

FAIRNESS POLICY
“Fairness” relates to the way an investment firm and its employees deal with clients in the matters of making and
providing investment analysis, recommendations or trade services. For example, most portfolio managers maintain
and manage accounts for a number of different clients. Some of those clients may have completely separate
accounts, but generally, there is a fair degree of overlap between the portfolios in similar mandates.
For instance, if a portfolio manager is buying a particular security, they would probably want to buy the same
security across all of those portfolios. The challenge regarding fairness is that frequently a portfolio manager is
unable to purchase or sell the entire position in a security for all of their clients in a single trade. Those trades may
take days to complete, particularly for less liquid securities.
Portfolio managers must have standards for allocating trades between their clients in a way that is fair, which is
usually outlined in a fairness policy. Allocation does not have to be equal, but it must be fair to all of the portfolio
manager’s clients. A fairness policy may cover trade allocations as follows:
• Trades can be allocated on the “first in, first out” rule; that is, client accounts receive shares on the basis of
having a trade ticket with an earlier time and date stamp than other clients with a similar trade request.
• Block trades of a single security should get the same execution price and commission rate.
• Partially executed block trades should be allocated on a pro-rata basis. For instance, an account with twice as
many shares as another account would get double the allocation.
• Issues in high demand (hot issues) and initial public offerings (IPOs) are assigned in one of three ways:
randomly, on a pro-rata basis or on a cycle schedule (meaning no account is assigned a multiple allocation until
the needs of all accounts have been satisfied at least once).

6
For more information about PIPEDA, please visit: http://laws-lois.justice.gc.ca/PDF/P-8.6.pdf.
7
National Policy 47-201, Trading Securities Using the Internet and Other Electronic Means, can be found at:
https://www.bcsc.bc.ca/Securities_Law/Policies/Policy4/PDF/47-201__NP__August_13__2013/.

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Portfolio managers will be well served by employing third-party software programs, many of which are available in
the marketplace, to handle the allocation of trades and commissions.

SOFT DOLLAR ARRANGEMENTS

A soft dollar arrangement is one in which an investment firm purchases services via commission dollars, rather
than via an invoice for the goods or services.

EXAMPLE
An investment firm may pay for investment research performed by a brokerage firm by agreeing to channel
an amount of trading business through the brokerage firm in an amount equal to the amount charged for the
service.

Another example is for services received that aid the investment firm in servicing its clients, such as the provision
of financial data terminals. In these cases, the brokerage firm would add a certain amount to each trade placed
through it by the firm, and apply it to the invoice amount of the terminal. The brokerage firm would actually pay the
invoice for the terminal, and then recoup its cost through the additional commission charge.
Many investors take a dim view of soft dollar arrangements, because they may appear unseemly and slightly
unsavoury. After all, other businesses have to invest their own money to make equipment or service purchases,
so why should investment firms be any different? The fact is that it has proven very difficult for brokerage firms to
separate out their research services from their trading activities, and charge for both.
Even so, the CFA Institute, the body to which all CFA charterholders (a large number of whom are portfolio
managers) belong, has published its standards for soft dollar arrangements that are binding on all CFA Institute
members.8 There are seven broad standards, as follows:
1. Brokerage is the client’s property. Members must seek client brokerage services on the basis of the best
execution at all times.
2. To allow clients to make the best decision, members must disclose to clients that soft dollar arrangements
may be entered into before employing soft dollars with that account.
3. Members must choose brokerage according to the brokerage firm’s ability to effect best trade execution, as
well as on the basis of its quality of research and overall service.
4. Members must evaluate whether the research purchased with soft dollars benefits clients in a specific and
measurable way.
5. Members must not direct brokerage from another account to pay for the client-directed brokerage.
6. Members must plainly disclose to clients its soft dollar arrangements and policies.
7. Members must keep accurate records of all soft dollar arrangements.

Soft dollar arrangements are an accepted part of the investment business and channelling of commissions. The
main point about using soft dollar arrangements is that they must be fully and plainly disclosed to a client before
they are put into effect, and if the client is not in agreement, the arrangements must not be entered into for that
account.

8
CFA Institute Soft Dollar Standards: Guidance for Ethical Practices Involving Client Brokerage (Charlottesville, Virginia: CFA Institute, 1998;
reprinted 2004, corrected 2011). Available online at: https://www.cfainstitute.org/-/media/documents/code/other-codes-standards/soft-
dollar-standards-corrected-2011.ashx.

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FINANCIAL TRANSACTIONS AND REPORTS ANALYSIS CENTRE OF

CANADA (FINTRAC)
The Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA) requires financial institutions to
verify the identities of their clients and to report any activity tied to money laundering or terrorist financing.9 The
PCMLTFA established Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) to be the agency
responsible for ensuring compliance with the PCMLTFA and for dealing with reported and other information.
FINTRAC collects, analyzes, assesses and discloses information to assist in the detection, prevention, and deterrence
of money laundering and terrorist financing. It is authorized to provide key identifying information on suspicious
transactions to law enforcement agencies if there are reasonable grounds to suspect that the information would be
relevant to investigating or prosecuting a money laundering offence. This information can also be provided to the
Canada Revenue Agency (CRA), the Canadian Security Intelligence Service (CSIS) and Immigration Canada if there
is reason to suspect tax evasion or a threat to national security. Investment and financial services businesses are
required to submit regular reports to FINTRAC on the following three transaction categories:

Suspicious transactions The definition of a suspicious transaction is very broad and covers virtually any
transaction that a financial firm has reason to suspect may be created for the purpose of
money laundering or the financing of a terrorist organization.

Large cash transactions Deposits of amounts of $10,000 or more in cash or electronic funds transfer (EFT).

Terrorist property Property in their possession or control that they believe is owned or controlled by or on
behalf of a terrorist group must be reported not only to FINTRAC, but also to the Royal
Canadian Mounted Police (RCMP) and CSIS.

Financial institutions are required to keep records of all suspicious or reportable transactions. Failure to do so can
result in a prison sentence and/or a fine for non-compliance.

COMPLIANCE WITH FINTRAC

The new client application form and its updating, where warranted, is a proven way to stay in compliance with the
fundamental Know Your Client (KYC) rule. FINTRAC requires portfolio managers to not only maintain a signed
account application on behalf of each client with signing authority over the account, but to also verify the account
opener’s identity through a government-approved photo identification card, such as a driver’s licence, passport or
similar form of identification.
The first step to meeting FINTRAC’s requirements is for portfolio managers to have in place a strong culture of
compliance in their firm, whether they act as their own compliance officers, in the case of smaller firms, or within
a larger organization. A culture of compliance instills the notion that compliance is not only the requirement of
regulatory bodies, but also good for clients, and thus ultimately good for business.
The second step is for portfolio managers, as well as principals and officers of firms, to be familiar with the
requirements of the PCMLTFA and their reporting obligations to FINTRAC. A detailed and easy-to-read outline is
available online at http://www.fintrac.gc.ca.
Finally, if a transaction is at all suspicious, the right course of action is to report it and allow FINTRAC, CSIS and the
RCMP to do their work. Firms are indemnified from liability in the case of reporting transactions that turn out to be
entirely legitimate, but can be subject to harsh penalties for failure to report suspicious transactions.

9
The complete text of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act is available at:
http://laws-lois.justice.gc.ca/eng/acts/p-24.501/.

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BEST PRACTICES
“Best practices” is a management term that refers to those processes and practices that most effectively deliver its
objectives. In an investment management firm, best practices translate into what is in the best interest of the firm’s
clients: practices that sustain a trust-based advisor-client relationship and meet a client’s investment objectives. A
firm’s standards of practice should address all of the best practices employed in dealing with clients, as well as those
dealing with regulators, the media and competitors. The standards should be an embodiment of the firm’s code of
ethics, both in spirit and to the letter.
A firm’s standard of practice should include guidelines on the following topics:

Best execution The requirement to seek the best execution for trades is also a standard under the
CFA Institute’s code of conduct. The definition of best execution is unclear at best. It
should be noted that best execution does not necessarily mean lowest cost, although
the attempt to keep commissions minimized should be a guiding principle. Portfolio
managers are entitled to consider trading ability, research capability and overall service
levels, as well as commission rates, when deciding upon best execution.

Maintaining proper One of the most common areas of deficiency that regulators identify when auditing
records firms is the failure to maintain proper records. Records serve as evidence of compliance;
are an enormous help in investigating occurrences, such as trading errors; and are a good
business practice. A firm’s standards should mandate which records are kept and outline
to clients why such records are kept.

Changing investment The process to identify, monitor and document investment objectives should be clear.
objectives This includes how changing investment objectives are implemented for clients and
whether they are still within a firm’s expertise or purview.

Trading errors A firm should have a clear and delineated trading protocol spelled out to minimize
errors. In the event of an error, a clearly identified process should be stated to deal with
the issue, including recourse; compensation to clients and investment dealers, if needed;
and the degree of participation of the firm’s legal and compliance departments.

Conflicts of interest Conflicts of interest, either real or perceived, should be disclosed to clients and
employers. This includes conflicts on an individual or firm level that might impair
independence and objectivity with respect to a client’s needs. If a conflict is overlooked,
its size or insignificance will not be an excuse.

Personal trading Best practices for personal trading should be closely tied to conflict of interest policies.
Procedures should be clearly in place to prevent investment staff from personally
benefitting at the cost of the client and the firm’s best interests. This topic is covered
further in Chapter 5.

Confidentiality and Although this is now mandated by law under PIPEDA (as we discussed earlier), a
client privacy statement of a firm’s practices about client privacy is a worthwhile effort. Portfolio
managers should remember that they are privy to the confidential financial information
their clients provide to them. They should strive at all times to maintain the
confidentiality of that information and protect its security.

Trading of non-public Insider trading is unethical and illegal. A firm’s standards of practice should make sure
information that either staff or clients do not tolerate such activity.

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Fair dealing and soft As detailed earlier, a firm has several strategies to deal with these matters, including the
dollar arrangements random allocation of securities purchases and also the disclosure of how soft dollars are
used.

Many of these best practices will be expanded on throughout this course. Ethics and best practices are of the utmost
importance in the investment management industry and should always be kept in mind.

DISCRETIONARY MANAGEMENT WITHIN AN IIROC DEALER MEMBER

In recent years, with the support and encouragement of their firms, more and more investment advisors have
evolved their business model from the traditional transaction-based model to a fee-based one. Many investment
advisors have taken this evolution even further by seeking the approval of their firm and IIROC to offer managed
accounts to clients.
The primary reason for this trend is that, under an advisor-managed account structure, the advisor and firm are
better able to offer more personal, direct, tax-effective and cost-effective discretionary services to high-net-worth
clients, many of whom do not have the time or expertise to manage their own investable assets.
Discretionary advisors are held to the highest legal standards in relation to their clients — a fiduciary standard,
which is explained in Chapter 2. As such, IIROC and its dealer members set quite stringent initial and ongoing
requirements for investment advisors who are operating managed accounts. The IIROC rules were mentioned earlier
in this chapter. Generally, IIROC dealer members will set even more stringent requirements around who they will
accept as a discretionary manager.

EXAMPLE
Some dealer members require an advisor to have been in their current role for a set number of years (for
example, five years), already have a large book of business (for example, in the $40-$50 million range) and have
a clean compliance record before they are eligible to be in the firm’s advisor-managed account program. These
requirements are above and beyond the IIROC proficiency requirements for discretionary advisors.

Discretionary advisors generally follow a model portfolio that is aligned with a client’s profile. Model portfolios
generally range from an aggressive portfolio, which is designed for a younger client who is able to tolerate more
risk, is focused on capital growth and has a long time horizon, to a conservative portfolio, which focuses more on
preservation and income generation for a client who may be in or nearing retirement.
Dealer members may manage a number of model portfolios that are based on a range of client objectives and risk
tolerance levels. It is a discretionary advisor’s key responsibility to align a client’s profile to the most appropriate
model portfolio. A key advantage of a discretionary account is that its trading system allows an investment advisor
to bulk all clients within their model for a particular trade, then make one trade without any calls to clients. Not
having to gain client approval on a trade-by-trade basis and then bulking the trades allows the advisor to make
more timely trades in client accounts.
In some cases, research and security selection within these portfolios is done by internal research or fund managers.
Advisors who prefer to outsource these activities, together with the help of the bulk trading order system, have
much more time for prospecting activities and to focus their practice more on relationship management and
financial planning.
Conversely, rather than outsourcing model portfolio construction, as well as research and security selection, some
discretionary advisors manage portfolios on the basis of their own model portfolios, while doing their own analysis
and making their own security selections. However, a dealer member must review and approve these model
portfolios before they can be offered to a client.

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It should be noted that most, if not all, investment advisors who manage discretionary accounts also have non-
discretionary accounts under their administration. Generally, a discretionary account is only offered to top-level
clients who have investable assets at or above a certain dollar amount. Smaller portfolios may not lend themselves
to managed accounts due to their cost structure and concerns that a feasible portfolio cannot be structured under a
certain dollar amount of investable assets.
As mentioned earlier, IIROC regulations require that a designated supervisor be responsible for the quarterly reviews
of managed accounts. Given the level of sophistication required to perform these reviews and the sheer number of
them a designated supervisor may be responsible for, this task could be outsourced to portfolio experts. However,
the accountability would remain with the supervisor. The benchmark metrics that could be used to evaluate the
performance of managed accounts include, among other factors, asset allocation, security quality and level of
diversification. Naturally, a portion of the review would involve ensuring that the discretionary advisor has generally
stayed within the portfolio’s stated mandate.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe what a portfolio manager is.
A portfolio manager is an individual, or a team of individuals, who advises clients, which can be individuals
or different types of institutional investors, on investments that are appropriate to a client’s individual
circumstances and investment objectives.

2. Identify and explain the various dealer, advisor and individual registration categories available in Canada.
Firms can fall into several registration categories under the two main categories of dealers and advisors.
Some of the relevant dealer categories include investment dealer, mutual fund dealer, scholarship plan
dealer, exempt market dealer and restricted dealer. The advisor categories are portfolio manager and
restricted portfolio manager.
The registration categories for an individual who, under securities legislation, is required to be registered
to act on behalf of a registered firm are dealing representative, advising representative, associate advising
representative, Ultimate Designated Person and chief compliance officer.
Portfolio managers face a detailed set of educational requirements in order to be registered with provincial
regulators, including CSI’s Chartered Investment Manager (CIM) designation and the Chartered Financial
Analyst (CFA) Program. Portfolio managers also need to meet specific experience requirements.

3. Describe the regulatory environment in Canada.

Canada does not have a national securities regulator. Securities regulation in Canada falls under the
jurisdiction of the various provincial and territorial securities commissions.
The various provincial and territorial regulators have come together in the form of the Canadian Securities
Administrators (CSA), which works to harmonize rules and regulations across the country, where possible.
In many cases, the various securities commissions have delegated the regulation of the investment industry
to self-regulatory organizations (SROs).

4. Identify IIROC-managed account rules with respect to the documentation required and the account approval
and oversight process.
In order for a dealer member to approve a managed account, a client must sign a managed account
agreement, and the dealer member’s designated supervisor for managed accounts must accept it. The
managed account agreement must also clearly indicate the client’s investment objectives for the account
and the client must be provided with a copy of the member’s procedures to ensure the fair allocation of
investment opportunities among managed accounts.

5. Outline the various investment practices the Canadian Securities Administrators (CSA) regulates.
Activities that the CSA regulates include high closing, late trading, market timing, client privacy
requirements, trading securities on the Internet, fairness policy and soft dollar arrangements.

6. Explain the compliance requirements of the Financial Transactions and Reports Analysis Centre of Canada
(FINTRAC).
Investment and financial services businesses are required to submit regular reports to FINTRAC on the
following three transaction categories:
« Suspicious transactions: The definition of a suspicious transaction is very broad and covers virtually any
transaction that a financial firm has reason to suspect may be created for the purpose of money laundering
or the financing of a terrorist organization.

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« Large cash transactions: Deposits of amounts of $10,000 or more in cash or electronic funds transfer (EFT).
« Terrorist property: Property in their possession or control that they believe is owned or controlled by or on
behalf of a terrorist group must be reported not only to FINTRAC, but also to the RCMP and CSIS.
FINTRAC requires portfolio managers to not only maintain a signed account application on behalf of each
client with signing authority over the account, but to also verify the account opener’s identity through
a government-approved photo identification card, such as a driver’s licence, passport or similar form of
identification.

7. Outline some of the investment management industry’s best practices.

“Best practices” is a management term that refers to those processes and practices that most effectively
deliver its objectives.
A firm’s standard of practice should include guidelines on the following topics: best execution, maintaining
proper records, changing investment objectives, trading errors, conflicts of interest, personal trading,
confidentiality and client privacy, trading of non-public information, and fair dealing and soft dollar
arrangements.

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Portfolio Management 2

CONTENT AREAS

Ethics

Code of Ethics

Trust and Fiduciary Duty

LEARNING OBJECTIVES

1 | Explain the importance of ethics in the investment management industry.

2 | Explain how end and means values form a value system.

3 | Explain how a value system influences a portfolio manager’s behaviour.

4 | Explain what an ethical dilemma is.

5 | Identify the primary pattern of a value conflict that results in an ethical dilemma.

6 | Identify the strengths and weaknesses of a code of ethics.

7 | Explain the best practices relating to a firm’s code of ethics.

8 | Explain trust and fiduciary duty.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

beneficiary fiduciary duty

code of ethics means values

end values prudent man rule

ethical dilemma trust

ethical principles values

ethics value system

fiduciary

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INTRODUCTION
Investment management is a business of trust. If one or more parties are acting unethically, there can be no trust.
From the perspective of someone outside of the securities industry, such as a client, the issues of ethics, trust, and
fiduciary duty might seem straightforward. An outsider might logically assume the following:
• An investment advisor or portfolio manager should ensure that the client’s interests come first.
• From their first meeting with a client, an advisor’s actions should indicate that they will always put the client’s
interests first.
• An advisor is aware that most retail clients rely on their knowledge and experience to provide guidance on
financial matters, unless otherwise agreed upon. This is especially true in the case of an advisor who exercises
discretionary authority.

Most firms of any size are staffed with a number of resources for discretionary portfolio managers to consult, with
department supervisors being a logical first step.
For the purposes of this chapter, we use the term discretionary portfolio manager to mean both an IIROC
Registered Representative (RR) who has discretionary authority over an account and a portfolio manager–advising
representative who falls under the provincial securities commission’s jurisdiction.
Compliance departments are another excellent source of guidance. Compliance officers are trained in securities
regulation and have a network of contacts from which to draw.
However, an investment advisor or portfolio manager may need to make decisions quickly on matters affecting a
client that might not seem as straightforward as the aforementioned assumptions suggest. These types of decisions
are discussed in this chapter, which introduces the concepts of ethics, values, ethical dilemmas, code of ethics, trust,
and fiduciary duty. For information only, a summarized, headings-only version of the Canadian securities industry’s
Standards of Conduct is provided in the Appendix.
Discretionary portfolio managers work very hard to attain their positions and academic credentials. An
accomplished career in portfolio management is one that strives to embody both intellectual and moral excellence.
In the first chapter, we explained the management term “best practices”. Ethics play an integral role in best
practices. The relationship between best practices, compliance and ethics should be fully understood in order to
enhance an investment firm’s and a discretionary portfolio manager’s objectives.

ETHICS

WHAT IS MEANT BY ETHICS?

Ethics serve as a foundation for the rules of the financial services industry and provide a structure that allows
participants to interpret and evaluate any circumstances. However, following industry regulations comprises only
the bare minimum of ethical behaviour. Ethics represent a whole approach to dealing with the industry’s various
stakeholders. In the long run, good ethics are good business.
Ethical principles help guide behaviour in situations where no regulations exist or apply. These principles may be
influenced by public opinion, consumer demand or advocacy groups, all of which may raise ethical behaviour to a
level higher than the minimum standards set out by the regulators.
Often, the media widely exposes and reports on unethical conduct, such as insider trading or the misuse of
client funds. This attention can damage the reputations of all parties involved. Therefore, efforts to avoid ethical
misconduct in the first place can help safeguard the interests of clients, registrants (both individuals and firms), the
industry and capital markets.

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In a general sense, ethics may be defined as a set of consistent values that guide individual behaviour, such as
accountability, fairness, honesty, loyalty, reliability and trustworthiness. However, in essence, the term has three
distinct meanings, as follows:
• The standards that govern the behaviour of a particular group, such as a profession.
• A set of moral principles or values. Morals are the norms of an individual or society established with
reference to standards of right and wrong. Moral standards address the right and wrong of telling the truth or
undertaking some action that may cause harm to others, for example. Moral standards are based on reason, and
authoritative bodies cannot establish or change them. Although, moral standards may underpin decisions made
by those authorities.
• The study of the general nature of morals and moral choices that individuals make. Occasionally, the term
ethics may even be used to refer to the study of morality.

In this chapter, ethics are portrayed as a continuous process of examining behaviour and making decisions in the
context of moral principles.

WHAT ARE VALUES?

Morality, integrity, trust, honesty and competency are values prized by all professionals, not just advisors, working
in the securities industry. The absence of any of these values may compromise the reputation and public perception
of advisors as individuals, and of the industry as a whole. This is because values apply to almost every decision a
person makes.
Values have the following common characteristics:
• They are beliefs, not facts.
• They are long-lasting, but not necessarily unchangeable.
• They guide individual and corporate behaviour, and goals.

Values that influence the goals a person would like to achieve can be separated into end values and means values.
• End values represent the ends toward which a person strives and influence how a person acts today to achieve
tomorrow’s goals. They include a sense of accomplishment, family security, self-respect, social recognition and
wisdom.
• Means values are the actions taken in the present to achieve a future goal. These include ambition, competence,
honesty, independence and responsibility.

A unified value system is one in which the ends and means mutually reinforce and support each other. Individuals
and corporations get into trouble when their means values do not support their end values.
A portfolio manager’s value system will accomplish the following:
• Influence their perception of situations and problems.
• Influence their decisions and solutions to problems.
• Set limits on their understanding of what constitutes ethical behaviour.
• Help them resist when they are being pressured to do something that they believe is wrong.

Value systems represent what an individual believes is important and what needs to be emphasized. In making
decisions, individuals are faced with many possible solutions. Clearly articulated values guide the determination of
priorities and goals in making those decisions. They tell the world what a person stands for.

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At the corporate level, values are usually articulated in a code of conduct and code of ethics. In their personal or
corporate actions, portfolio managers need to ensure that articulated values guide the selection of objectives and
that personal and/or corporate objectives do not dictate the selection of values.

ETHICAL DILEMMAS
Conflicts in values can fall into two general categories: right versus wrong, and right versus right. In the case of right
versus wrong, it is usually quite obvious what the proper decision is, because some element of the situation provides
clear guidance, such as:
• One choice is clearly illegal.
• One choice lacks a basis in truth.
• The negative consequences of one particular decision will far outweigh any possible positive results.
• The proposed action does not conform with the code of fundamental inner values that are widely shared and
understood, and that define what is considered to be right or wrong actions.

Right versus wrong issues tend to be black and white. A code of conduct, a code of ethics and compliance policies
are mainly concerned with right versus wrong issues. However, most situations involve a number of possibilities,
and each possibility has some right and some wrong elements. The difficulty is in determining the right decision.
An ethical dilemma exists when two or more of the possible choices pit different values against each other. For
example, one choice would lead to the fulfillment of an end value, such as social recognition, yet at the cost of a
means value, such as honesty, while another would fulfill the end goal of self-respect, yet at the cost of a means
value, such as ambition.
The most difficult ethical dilemmas to resolve are those of right versus right. Each of the possible solutions to the
problem has a degree of right and none of the possible solutions appear to be clearly wrong.
The following are the four primary patterns of value conflict that result in ethical dilemmas:
• Truth versus loyalty: The values of honesty or integrity clash with the values of commitment, personal
responsibility or keeping a promise.

EXAMPLE
You discover that several senior portfolio managers — including your boss and mentor, who gave you a chance
and hired you — are very seriously stretching the trading rules to their benefit. They have not actually broken the
law, but they are getting close. Do you keep quiet or report them, likely causing your mentor to be fired?

• Individual versus group: The values of an individual clash with the rights or values of a group. This type of
dilemma may appear in the form of “us versus them” or “self versus others”.

EXAMPLE
A new fee structure is proposed at your firm. It will greatly benefit the firm as a whole and those senior portfolio
managers who have many high-net-worth clients, but it will not benefit you because you are new and still have
just a few clients. In fact, it might even reduce your income. Do you vote for or against the new fee structure?

• Short term versus long term: Immediate needs or desires run counter to future goals or prospects.

EXAMPLE
A client has specified her desire for both long-term safety and growth in her account. You see the opportunity to
suddenly make a great deal of money for her, but it is risky. Do you make the trade in the client’s account?

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• Justice versus mercy: The values of fairness, equity and righteousness conflict with the values of compassion,
empathy and love.

EXAMPLE
A new employee, who has tremendous potential and is doing well in all other respects, is breaking an important
company policy. This is the second time he has done so, but the first time a senior employee told him the policy
is “actually more of a guideline” and that “everyone does it”. Do you fire the new employee or give him another
chance?

Although resolving each dilemma requires time and thought, it is important to avoid rationalizing behaviour
by trying to put one’s actions into the context of so-called accepted norms. Typical rationalizations include the
following:
• If I do not do it, somebody else will.
• It does not hurt anyone.
• That is the way it has always been done.
• If everybody else does it, then it must be okay.

Rationalizations are not values; rather, they are excuses for following a course that conflicts with values.

Case Study #1 | Where is My Research?

The investment firm that you work for has an investment banking relationship with ABC Corp., which has recently
received controversial takeover offers from two suitor companies. As such, the investment research department is
not able to render an opinion on the status of the current takeover offers or any other opinion on ABC Corp.
Rachel Stein is a client who owns several thousand shares of ABC Corp. in her private investment management
account. She has telephoned you to ask what to do with her ABC Corp. holdings. Mrs. Stein is quite adamant that
your firm’s opinion be conveyed to her, as she wants to be able to make an informed decision as to which suitor’s
offer she should accept. She requests that the latest comments from your research department on ABC Corp. be
sent to her so she can consider her options.
1. Do you give her an opinion?
2. Do you explain to her the circumstances of the current situation between your firm and ABC Corp.?
3. Do you use third-party research to satisfy her request?

Case Study #2 | Conflicting Views

Ronald Greene is a 78-year-old client who holds a discretionary managed account with you. Mr. Greene is an
experienced investor who has a thorough understanding of capital markets. He has stated that his investment
objectives are highly conservative. You also manage accounts for his son and daughter, who are both in their mid-
forties.
Lately, Mr. Greene’s son has suggested his father’s account should be rebalanced to reflect his and his sister’s
investment objectives since they will ultimately be receiving the assets upon their father’s death. Both he and his
sister feel that a more growth-oriented portfolio would be in their best interests, since their father does not rely on
the portfolio for his day-to-day living requirements.
1. What should be your response to Mr. Greene’s son?
2. Should you broach the subject with Mr. Greene?

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CODE OF ETHICS
A written code of ethics and conduct is an excellent way to reinforce a strong ethical sense. An appropriate code of
ethics is an integral part of ensuring that a discretionary portfolio manager’s fiduciary duty is performed and that all
clients and investors are treated fairly and appropriately. It also helps to ensure an investment management firm’s
proper functioning. An institutional investment management firm’s inability to conduct its affairs in accordance
with its own code of ethics can result in the loss of professional designations and regulatory licences for both the
staff and the firm.
A firm’s code of ethics should be reviewed regularly and updated when necessary. Clients should be made aware of
the existence of such a code. Presenting a client with a firm’s code of conduct is a written promise of how you will
treat them and their account.
Most institutional investment management firms have adopted a particular code of ethics. Occasionally, the code
that is adopted is unique to a firm. However, the majority of institutional investment management firms have
adopted the CFA Institute’s Code of Ethics.

STRENGTHS AND WEAKNESSES

A code of ethics has both strengths and weaknesses. The following are some of its strengths:
• It confirms that the company or industry is prepared to be explicit about ethics.
• It can be a valuable, formal and updateable expression of appropriate behaviour. A well-written code clearly
identifies appropriate behaviour and may enhance a registrant’s perception of ground rules. When evaluating
actions, this guidance should help a registrant judge what is right and wrong, as distinct from effective or
ineffective.
• It provides a social contract for the workplace, and a basis for working together in reciprocal dignity and fairness.
• It supports an individual’s and a firm’s responsibilities and accountabilities. Without a code, a wrongdoer can
claim (often with some justification) that there were never any rules, or that they were not sufficiently explicit.

However, a code of ethics is neither a prerequisite for, nor a guarantor of, ethical behaviour. The following are some
of its weaknesses:
• It may lull management and regulators into a false sense of security, believing that the mere existence of a code
is sufficient to ensure ethical conduct. A code can often end up gathering dust in drawers. To be effective, it
must be well supported and reinforced.
• It typically deals with resolving conflicts between right and wrong, but not with the more complex and difficult
conflicts between two rights.
• It may focus on what to do without explaining why. To be effective, a code should not simply mirror problems
that may have spurred its introduction in the first place. A code should also be based on broad ethical principles,
so that employees and registrants are appropriately guided in all situations, whether explicitly addressed in it or
not.
• It may only deal with an employee’s obligations to their employer, and not the employer’s obligations to an
employee, such as professional development, personal respect, a fair workplace and freedom from harassment.
• A poorly written code may contain policies that are inconsistent with an industry or firm’s investment
philosophies and incentive strategies.

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For a code of ethics to be effective, the following four elements are necessary:

Senior management must Why would employees abide by a code that senior management does not
support it follow? Senior executives should be seen as having or having had an active role
in the development of a firm’s code of ethics. Management should also foster
ethics in every message they convey, both in what they say and do.

Employees, at all levels, must By actively including its employees in the process, the firm garners support
participate in its development for the project. It can show that a code of ethics is not just about sending a
and reinforcement message from management, but is also an issue that requires input from all
levels.

Its training and reinforcement Training should take place when an employee joins a firm and should be
must be implemented repeated at regular intervals. The value of reinforcing a code of ethics is two-
fold. First, it can give meaning to and extend specific applications of normative
values and rules. Second, it defines how much freedom, responsibility and trust
is being vested in staff and managers to apply these principles on a daily basis.

It should be reviewed Management and employees should reaffirm an existing code of ethics or
periodically and updated when amend it as necessary. This will retain the code’s relevancy in the current
necessary environment.

BEST PRACTICES
Compliance and adherence to an institutional investment manager’s code of ethics should begin as of an
employee’s first day on the job. The employment hiring process should include a review and discussion with the
employee of the firm’s adopted code of ethics. Upon hiring, the employee should promptly deliver the appropriate
signed verification that they have read and understood the firm’s code of ethics.

Good business practice Distributing the firm’s code of ethics to all affected employees at least on an annual basis
is good business practice. This practice should also include having all recipients reaffirm,
in writing, their commitment to adhere to the firm’s code of ethics.

An institutional investment management firm must also ensure that its operations and compliance personnel
integrate monitoring processes and procedures to ensure strict adherence of the firm’s employees to its code of
ethics.

EXAMPLE
A prime example relates to the personal investment activities of the institutional investment manager’s staff.

Written personal The firm must have written personal trading guidelines that apply to its affected staff. It
trading guidelines is also very important that effective administrative processes and procedures are created
and implemented that allow designated staff, usually the compliance department, to
implement the firm’s personal trading guidelines.

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Prior approval process It is fairly common for institutional investment management firms to build their personal
trading guidelines around an effective prior approval process. In essence, the process
requires that all affected employees obtain written confirmation of permission from
designated compliance or senior management personnel prior to placing trades in their
personal account.

Standard follow-up procedure requires that an employee have the brokerage firm with which they trade their
personal account send a copy of their security transaction confirmations and month-end account holding reports
directly to the institutional investment management firm’s compliance department. The compliance department
staff then conducts a reconciliation to ensure that all of the security transactions in the employee’s personal trading
account obtained the institutional investment management firm’s written approval prior to the trade’s execution.

TRUST AND FIDUCIARY DUTY

TRUST
Trust is the belief that those people on whom we depend, either by choice or circumstance, will meet the
expectations we have placed on them; however, trust does not just happen naturally. A client has to make a
conscious choice to trust their investment advisor. A portfolio manager has to make a conscious choice to trust
their employer, assistant, colleagues and clients. A client’s trust in a portfolio manager is based on the portfolio
manager’s reputation, which is acquired over time through consistent ethical behaviour. Three elements must be
present for trust-based relationships to develop between portfolio managers and their clients:

The portfolio manager has Given the emphasis on proficiency requirements in the Canadian investment
specialized knowledge that the industry, it is assumed that all portfolio managers have more knowledge about
client does not have investing and securities in general than the average client.

The portfolio manager belongs All properly licensed discretionary portfolio managers in Canada are subject to
to an industry that is well the rules, regulations and ongoing scrutiny of at least one regulatory body. In
regulated many instances, there is regulatory oversight by multiple regulators.

The portfolio manager places Discretionary portfolio managers must meet this last principle. Unfortunately,
the interests of the client this is the source of most ethical dilemmas that today’s portfolio managers face.
before their own

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Case Study #3 | Do I Know My Client?

Mr. Wilcox is a client in his late forties who has stated that his investment objectives are aimed at growth and
moderate risk exposure. Several months ago, Mr. Wilcox suffered a concussion in a skiing accident but appeared to
make a complete recovery.
Lately, Mr. Wilcox has been increasingly agitated about the performance of his account and has made suggestions
that a more aggressive stance be taken in the management of his account. During a recent telephone conversation,
Mr. Wilcox made illogical comments that were contrary to his usual analytical approach. He said he is willing to
assume much greater levels of risk than his stated investment objectives indicate. After witnessing several months
of deteriorating good judgment and heightened emotional instability by Mr. Wilcox, you become convinced he
may have suffered a mild traumatic brain injury that is proving to be detrimental to his ability to provide the proper
parameters for his investments.
1. Do you continue to accept Mr. Wilcox’s increasingly illogical demands?
2. Do you have the obligation to report your suspicions about Mr. Wilcox’s condition to anyone?
3. What steps would you take to ensure Mr. Wilcox’s well-being and protect your position as his portfolio
manager?

The trust relationship between a discretionary portfolio manager and their client is based on two principles:
competence and integrity. Both are essential in building a trust relationship with a client. Competence without
integrity leaves a client at the mercy of a self-serving professional. Integrity without competence puts a client in
the hands of a well-meaning but inept individual. A portfolio manager’s ability to communicate competence and
integrity is the key to establishing trust with any client.
In any meeting a discretionary portfolio manager has with a prospective or current client, they must do the
following:
• Listen intently to what the client is saying.
• Not be manipulative, exploitative or deceptive.
• Admit when they do not know something.
• Perform all tasks competently.

Trust is expressed by way of three constant elements in a relationship with a client, as follows:

Disclosure of The freer the flow of information between a portfolio manager and their client, the
information greater the possibility that a strong bond of trust will form.

Influence over A client must know that the information they are sharing with their portfolio manager is
decisions positively affecting the decision-making related to the client.

Exercising control A client feels some control over the relationship with their portfolio manager, and does
not feel manipulated or patronized.

When a client is determining the level of trust they place in a discretionary portfolio manager, some of the key traits
they look for are competence, awareness of their needs, compassion, fairness, openness and consistent behaviour.

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FIDUCIARY DUTY
The fiduciary role carries with it the highest standard of care. Often, a person who holds a position of trust has a
duty to the individual who has placed trust in them. This could be in connection with the care of assets or when they
are responsible for the personal affairs of others. This is called a fiduciary duty. The person in whom the trust has
been placed is called a fiduciary; the person to whom the fiduciary owes this duty is called the beneficiary.
A fiduciary relationship may exist where there is a special relationship of confidence and trust. A fiduciary duty may
be defined as the duty of a person in a position of trust to act solely in the beneficiary’s interest without gaining
any material benefit, except with the knowledge and consent of the beneficiary. This may occur when a person has
a reasonable expectation that another party (the fiduciary) will act in their (the beneficiary’s) best interests and on
their behalf. A fiduciary should not profit at the beneficiary’s expense. Fiduciary duties have been found to exist in
such relationships as a doctor and a patient, a lawyer and a client, and a director and the corporation they serve.
When disputes between dealer members and clients are resolved through civil litigation, the courts may hold
that a Registered Representative (RR) owes a fiduciary duty to a client if the RR provides investment advice and
recommendations to the client, and the client relies on such advice. Criteria that may be used to determine whether
a fiduciary duty is present in an RR-client relationship include the client’s high degree of reliance on the RR’s advice
and their vulnerability.
The existence of such a fiduciary duty imposes a higher standard of care upon the RR than would be the case if they
merely executed a client’s orders without providing any advice. Regardless of whether or not a fiduciary duty exists,
an RR has a duty under provincial and territorial securities laws to deal fairly, honestly and in good faith with their
clients.

FIDUCIARY DUTY AND DISCRETIONARY AUTHORITY

There is a distinct difference between the standard to which an RR with and without discretionary authority is held.
While RRs without discretionary authority may be held to a fiduciary standard depending on the advisor-client
relationship (as mentioned above), those with discretionary authority are without exception considered to be a
fiduciary. The existence of a fiduciary relationship imposes the highest standard of care on an investment advisor.
The advisor must act carefully, honestly and in good faith in their dealings with clients, and not take advantage in
any way of the trust their clients have placed in them. Furthermore, the discretionary manager must not only make
the most suitable recommendations for a client, but must also avoid or disclose conflicts of interest.

FIDUCIARY DUTY AND INSTITUTIONAL INVESTMENT FUNDS

Many of the actions involved in operating an institutional investment fund are fiduciary duties, and the individual
or entity performing them is a fiduciary. Using discretion in administering and managing a fund or controlling its
assets make that person a fiduciary to the extent of that discretion or control. Thus, fiduciary status is based on the
functions performed for a fund, not just on an individual’s title.
A fund must have at least one fiduciary (an individual or entity) named in its trust indenture, or through a process
described in trust documents as having control over the fund’s operation. The named fiduciary can be identified by
office or name. Normally, a fund’s board of trustees has the ultimate fiduciary responsibility, although for some
funds it may be an administrative committee or a company’s board of directors.
A fund’s fiduciaries will ordinarily include the trustee, investment advisors, all individuals exercising discretion in the
fund’s administration, all members of the fund’s administrative committee (if it has such a committee) and those
who select committee officials. Lawyers, accountants and actuaries are not generally fiduciaries when acting solely
in their professional capacities. The key to determining whether an individual or entity is a fiduciary is whether they
are exercising discretion or control over a fund.

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FIDUCIARY DUTY AND CORPORATE PENSION PLANS

In the case of a corporate pension plan, a number of decisions are not fiduciary actions, but rather business decisions
made by the employer who sponsors the pension plan. For example, the decisions to establish a pension plan,
determine the benefits package and include certain features, as well as amend the plan or terminate it, are all
business decisions, not fiduciary decisions. When making these decisions, an employer is acting on behalf of its
business, not the pension plan, and therefore is not a fiduciary. However, when an employer (or someone it hired)
takes steps to implement these decisions, the employer is acting on behalf of the pension plan and, in carrying out
these actions, is a fiduciary.

WHAT IS THE SIGNIFICANCE OF BEING A FUND’S FIDUCIARY?

Fiduciaries have important responsibilities and are subject to standards of conduct because they act on behalf of a
fund’s investors and beneficiaries. These responsibilities include:
• Acting solely in the interest of a fund’s participants and their beneficiaries, and with the exclusive purpose of
providing benefits to them.
• Carrying out their duties prudently.
• Following a fund’s documents or trust indenture.
• Diversifying a fund’s investments.
• Paying only reasonable fund expenses.

Case Study #4 | Unconventional Investment

Fran Tucker is employed in the Personal Wealth Management (PWM) division of a large bank. Recently, sales
management has been presenting a new investment opportunity for growth-oriented clients. The bank has
securitized mortgage loans and plans on marketing them to wealthy clients through a pooled fund.
During a sales conference call, Mr. Tucker and other members of the PWM division are told about the benefits and
risks associated with the new investment opportunity. As an incentive to market these investment vehicles, lucrative
performance bonuses have been offered to those advisors who place clients in the pooled fund.
Mr. Tucker has a limited knowledge of the fundamentals of the new investment opportunity, and his experience
has made him very cautious with respect to such “exotic” products. Friends of his that are also in the securities
business have often spoken of the hazards of such investments. Considering all the facts, Mr. Tucker does not feel
comfortable with the product and is very hesitant to offer it to his clients.
1. Should Mr. Tucker ignore his concerns and offer the product to his clients who meet the investment objective
criteria?
2. Should Mr. Tucker voice his concerns to his superiors?
3. Should Mr. Tucker re-educate himself about the product to see if he may change his opinion and thereby
enhance his compensation?

THE FIDUCIARY AND THE PRUDENT MAN RULE

The prudent man rule, also known as the prudent person rule, originates from U.S. common law dating back to the
early 1800s. It directs the fiduciary to observe how a person of prudence, discretion and intelligence manages their
own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, while considering
the probable income, as well as the probable safety, of the capital to be invested.
The rule mandates that a person acts thoughtfully and carefully given a particular set of circumstances. For
example, a trustee observes the prudent man rule by preserving a trust’s assets for its beneficiaries.

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The fiduciary is required to invest a client’s assets as they would invest their own property, all with the following
factors in mind:
• The beneficiary’s expectations with respect to their investment objectives.
• The need to preserve the fund or portfolio’s capital.
• The amount and regularity of income that the beneficiary requires.

The prudent man rule requires that each investment be judged on its own merits. Under this rule, speculative
or risky investments must be avoided. Certain types of investments, such as second mortgages or new business
ventures, are viewed as intrinsically speculative and therefore are often prohibited as fiduciary investments.

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SUMMARY
After completing this chapter, you should be able to:
1. Explain the importance of ethics in the investment management industry.
Ethics serve as a foundation for the rules of the financial services industry. Ethical principles help guide
behaviour in situations where no regulations exist or apply.

2. Explain how end and means values form a value system.

A unified value system is one in which the ends and means mutually reinforce and support each other.
Individuals and corporations get into trouble when their means values do not support their end values.

3. Explain how a value system influences a portfolio manager’s behaviour.

A portfolio manager’s value system can influence their perception and decisions, limit their knowledge of
ethical behaviour and help them when they are being pressured.

4. Explain what an ethical dilemma is.

An ethical dilemma exists when two or more of the possible choices pit different values against each other.

5. Identify the primary pattern of a value conflict that results in an ethical dilemma.
The four primary patterns are truth versus loyalty, individual versus group, short term versus long term, and
justice versus mercy.

6. Identify the strengths and weaknesses of a code of ethics.

Strengths include the following: Can be a formal and updateable expression of appropriate behaviour,
provides a social contract for the workplace, and supports an individual’s and firm’s responsibilities and
accountabilities.
Weaknesses include the following: May lull management and regulators into a false sense of security,
typically deals with resolving conflicts between right and wrong, may focus on what to do without explaining
why, may not deal with an employer’s obligations to staff and may be inconsistent with an industry or firm’s
philosophies and incentive strategies.

7. Explain the best practices relating to a firm’s code of ethics.

Good business practice: Distributing the firm’s code of ethics to all affected employees at least on an annual
basis.
Written personal trading guidelines: The firm must have written personal trading guidelines that apply to its
affected staff.
Prior approval process: Requires that all affected employees obtain written confirmation of permission from
designated compliance or senior management personnel prior to placing trades in their personal account.

8. Explain trust and fiduciary duty.

Trust is a belief that people we depend on will meet our expectations. Trust is expressed in a client
relationship through the disclosure of information between parties, a client seeing the positive effect of the
decisions from the disclosed information and a client feeling some control over the relationship.
A fiduciary duty involves a person in a position of trust acting solely in the beneficiary’s interest.

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APPENDIX

CANADIAN SECURITIES INDUSTRY – STANDARDS OF CONDUCT

(SUMMARIZED; FOR INFORMATION ONLY)
• Duty of Care
Know Your Client
Due Diligence
Unsolicited Orders

• Trustworthiness, Honesty and Fairness

Priority of Client Interests
Protection of Client Assets
Complete and Accurate Information
Disclosure

• Professionalism
Client Business
« Client Orders
« Trades by Registered and Approved Individuals
« Approved Securities
Personal Business
« Personal Financial Dealings with Clients
« Personal Trading Activity
« Other Personal Endeavours
Continuous Education

• Conduct in Accordance with the Securities Acts

Compliance with the Securities Acts and SRO Rules
« Insider Information

• Confidentiality
Client Information
Use of Confidential Information

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CONTENT AREAS

Financial Intermediation

Governance

LEARNING OBJECTIVES

1 | Explain the role of financial intermediation in the function and growth of capital markets.

2 | Describe the various groups of institutional investors and explain each of their activities.

3 | Explain the role of other industry participants.

4 | Describe the principal-agent relationship in investment management.

5 | Describe the regulatory environment in domestic institutional investment management and the
roles of the Office of the Superintendent of Financial Institutions (OSFI) and the Ontario Securities
Commission (OSC).

6 | Describe the roles of the board of trustees, investment committee, investment consultant and
investment manager in governing an investment fund.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

board of trustees investment committee

collective investment vehicles investment policy statement

defined benefit (DB) Office of the Superintendent of Financial

Institutions (OSFI)
defined contribution (DC)
Ontario Securities Commission (OSC)
endowment funds
pension consultants
financial intermediaries
plan sponsor
financial intermediation
pooled investment vehicles
institutional investors

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INTRODUCTION
For a growing economy, the primary source of capital is individual investors. However, it is too expensive and
generally impractical for individuals to directly lend to or invest with the primary users of capital, governments and
corporations. These users need a massive amount of funds in relation to an individual investor’s available capital.
Furthermore, because of economic growth and the effects of inflation, both the supply of and demand for capital
have grown substantially over time.
Financial intermediaries — including banks, life insurance companies, mutual funds, pension plans and others —
have responded to this growing opportunity by creating and distributing investment products and services that
meet individual investors’ various financial goals. The success of these intermediaries at distributing such products
and services has allowed them to amass large amounts of capital by essentially combining or pooling individual
investors’ capital. With these large pools of capital, intermediaries can lend or invest funds on more favourable
terms than those of individual investors. Indeed, most of these investment opportunities are not otherwise available
to individual investors, because of the small amount of funds typically available to them for investment. For
individual investors, well-designed financial products that give an attractive and competitive share of the benefits
have also fuelled the growth of institutional pools of capital.
The success of financial intermediaries, especially relative to industrial companies, is readily apparent by looking
at the size of the largest financial institutions in Canada — and the same is true for other Western countries. In a
given country, the largest financial institutions rank among the top 10 corporations, regardless if it is in terms of
capitalization or even the number of employees. In Canada, the various firms and organizations that make up the
financial sector have been significant sources of employment and economic growth.
The purpose of this chapter is to outline the key aspects of each major type of financial intermediary that is
operating in Canada. It will discuss in detail the financial intermediary’s role as an institutional investor, and the
nature of the relationships involved in the institutional investment management process, which differ substantially
from typical individual investor relationships. This chapter will also examine and describe fund governance in terms
of each institutional investment management participant’s typical roles and responsibilities.

FINANCIAL INTERMEDIATION
Essentially, financial intermediation involves the movement of funds between those who supply capital and those
who use it. The primary sources of capital are depositors, lenders, policyholders and investors. The users of capital
are typically governments and corporations, as well as individuals by way of consumer financing products, such as
home mortgages, automobile loans and credit cards. The various companies and organizations that connect and
move capital between these two groups are commonly referred to as financial intermediaries.
Up until the mid-1960s, the primary financial intermediaries were banks and life insurance companies. After the
mid-1960s, a number of factors encouraged the growth of other types of financial intermediaries, including mutual
funds, pension plans and endowments. Six of these major factors were as follows:
1. Demographic influences, particularly those related to the maturing of the baby-boom generation and its
evolving financial planning needs.
2. The proliferation and growth of pension plans, driven by demographic trends and the competitive pressure on
corporations to attract and retain employees by offering post-retirement benefits.
3. Empowerment, as individual investors became more capable and comfortable in making their own investment
decisions due to better overall service in the financial services industry, less expensive and improved
technology and communications, and the expansion of the financial markets news media.
4. Innovation, through the creation of new types of securities and financial products to meet the ever-growing
financing needs of governments, corporations and individuals.

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5. Declining security transaction costs and the growth of low- or no-fee distributors of financial products, which
encouraged more individuals to invest in popular products, such as mutual funds.
6. Capital market liberalization and deregulation, which resulted in more competitive and cost-effective financial
markets, in turn fostering the growth of competitive investment products that better suited the needs of those
that provide and use capital.

Over the past 50 years, these six factors, among others, caused an explosion in the size, number and variety of
financial intermediaries. While all major types of intermediaries experienced tremendous growth, there was a large
shift in market share from banks and life insurance companies to mutual funds, pension plans and endowments.
Interestingly, although the industry expected individual investors to be far more active after these developments,
it was in fact the intermediary financial institutions that were more active. A prime example is the development of
futures, options and other financial derivatives since the 1980s. Individual investors have not embraced these types
of financial products. The biggest users of financial derivatives are the financial intermediaries themselves.
The interest of financial intermediaries in derivatives is driven by two main factors, as follows:
1. All financial intermediaries fall under one or more regulatory regimes. As regulatory environments become
more concerned with the risks they assume, financial intermediaries have used derivatives in their risk
management strategies and processes.
2. Financial intermediaries use financial derivatives extensively in the creation and management of customized
financial products for both their individual and institutional investors. These types of investment products
typically include features that provide a guarantee of principal protection and often some degree of exposure
to selected capital markets or economic indexes.

INSTITUTIONAL INVESTORS
Many financial intermediaries can be referred to as institutional investors. Traditionally, institutional investors
have been grouped as follows:
• Pension plans
• Mutual funds
• Insurance companies
• Endowments
• Charitable foundations
• Family trusts/estates
• Corporate treasuries

Despite the popular use of these categories, the terms themselves are increasingly not capturing the most
significant differences among industry players. For example, many insurance companies have launched their own
investment funds and have become involved in the management and provision of pension products.
Certain types of pension plans have a life insurance component to them, and both banks and life insurance
companies are acquiring or launching investment management companies. Some life insurance companies are
buying or building banking affiliates so they can offer their insurance clients savings and loan products. If anything,
there is increasing integration — and, with it, competition — among these traditional institutional investors.

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DID YOU KNOW?

Collective Investment Vehicles

The overall costs of attaining diversification tend to be large. This reality creates an incentive for
individual investors and institutions to place their money in collective investment vehicles. In North
America, collective investment vehicles are generally referred to as pooled investment vehicles. The
most popular pooled investment vehicles are as follows:
• Mutual funds
• Exchange-traded funds (ETFs)
• Hedge funds
• Venture capital funds
• Private investment partnerships

The primary objective of using pooled investment vehicles is to achieve an attractive risk-return profile
by pooling the assets of many investors, which lowers average costs through the following:
• Better diversification
• A more efficient collection and processing of information
• Spreading fixed operational costs over a larger asset base
• Using size as a tool in the market environment to obtain better security transaction terms, such as
smaller bid-ask spreads and commissions

Pooled investment vehicle investors are entitled to the investment portfolio’s net returns and,
accordingly, bear all associated investment and fund operational risks. The growth of pooled investment
vehicles has been so profound that mutual funds have become the primary investment vehicle for
individual investors.

PENSION FUNDS
Funded occupational or individual pension plans are the private sector counterparts of public social security
programs that are common in most Western countries. Occupational pension funds, which are typically sponsored
by large employers or trade unions, collect and invest contributions from the beneficiaries and sponsors for the
purpose of providing retirement entitlements to the beneficiaries.
The management of pension plan investments may be internal, meaning it is performed by the fund itself; external,
where it is delegated to independent external investment managers; or a combination of both. The use of external
(third-party) investment managers is the norm, particularly for small- to medium-sized pension plans that have
not attained an asset base that is sufficient in size to support the costs associated with creating and operating an
internal investment management staff.
Pension plans and other financial intermediaries tend to use third-party investment managers if they can offer
expertise in specialized areas such as hedge funds, private equity, and foreign or regionally focused markets.

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DIVE DEEPER

What is the difference between a defined benefit and a defined contribution pension plan?
The two main types of pension funds — defined benefit (DB) and defined contribution (DC) — differ
significantly in the distribution of investment risk between the sponsor and the beneficiary. In DB
programs, pension plan entitlements are typically calculated on the basis of an employee’s salary
profile and tenure of employment. These entitlements formally represent the sponsor’s liabilities, as
the sponsor is responsible for making contractual pension payments, regardless of how the investment
performs. With DB programs, a beneficiary’s risk tends to be limited to the sponsor’s default.
In contrast, under DC programs, the beneficiary is typically provided with a menu of investment choices
(including mutual funds) among which to allocate regular contributions. Beneficiaries take on the entire
investment risk, while the investments cumulative performance determines the payouts. Due to these
differences, DB pension liabilities tend to most closely resemble those of life insurers, in that the sponsor
will guarantee them. Due to the long-term nature of DB liabilities, which are effectively like inflation-
indexed long-term bonds, there is a potential for significant volatility in fund surpluses and deficits. This
means pension funds must focus their attention on risk management, as DB liabilities are difficult to
match on the asset side. As temporary swings in surpluses are unavoidable, investment horizons have
to be relatively long. On the other hand, the management of DC programs resembles more closely that
of a mutual fund. Because there is a wider product mix to offer and because DC funds do not have fixed
liabilities, their investment horizons can be in the short-, medium- or long-term range, and tend to vary
more across firms and products.
Prior to the 1980s, the vast majority of North American private pension plans were DB in nature.
However, both the number of employers offering DC plans and the amount of assets in them have
grown steadily and now constitute a substantial portion of North American pension plan assets. Younger
employees, a more mobile workforce that switches employers more often than in the past, as well as
the expense of carrying a DB plan on an employer’s statement of financial position and statement of
comprehensive income, are some of the reasons why this shift from DB to DC plans has occurred.

INSURANCE COMPANIES
Life insurance companies, which represent the largest segment of the insurance industry, offer products such as
annuities and guaranteed investment contracts that are tailored to the needs of individual and collective pension
plans. The return on the insurer’s asset portfolio and insurance elements determines the payoff of a life insurance
product. Therefore, life insurance products are an indirect way to provide ultimate beneficiaries with asset
management services.
However, insurance companies tend to differ from other institutional investors in their liability structure. Life
insurers’ liabilities are primarily actuarial in character, with fixed, income-like payout structures. This explains the
large portion of fixed income products in insurance portfolios. However, equity allocations have increased during
the past several decades, as life insurers have created and offered new life insurance products with valuations and
payouts based on equity market returns.
Insurance company assets are often managed internally rather than by external asset managers. This organizational
preference has led insurers to purchase external asset management firms if a particular investment expertise is
lacking in-house. As a result, some insurance companies now offer portfolio management and administrative
services to pension funds. In addition, there has been a recent trend among insurers to invest in or acquire
specialized investment vehicles and purchase specific asset management service providers.

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MUTUAL FUNDS
Mutual funds have also undergone phenomenal growth during the past four decades. This growth, both in the
number of funds and in the assets under management, led to the popular remark during the late 1990s that there
were actually more mutual funds available in the U.S. than there were companies listed on the New York Stock
Exchange. Although not entirely accurate, the remark was not that far from the truth. Mutual funds have become
the investment vehicle of choice for many individuals who do not have the time, inclination or resources to properly
research individual stocks and bonds to include in their portfolio.
Due to the economies of scale — and therefore the profit potential — the mutual fund industry has also undergone
much consolidation. Many mutual fund companies have also had to diversify and expand their product offerings to
meet new investor trends and demands. This development has been very prevalent in the area of offering investors
exposure to international capital markets.
Mutual funds with global mandates have grown in popularity as investors become more convinced of the
importance of diversifying their mutual fund investments beyond their domestic market. Another prominent
product trend has been the offering of specialist mandates. Many of the specialist-type mandates are focused on
industry sectors. These products offer exposure not only to traditional market sectors such as precious metals, but
also to established but still quickly growing industry sectors such as information technology and wireless.
Another reason for growth in the mutual fund industry is that some mutual fund companies have diversified their
investor base beyond the traditional individual investor. In search of additional assets to manage, they have often
taken their existing investment mandates and products, and repackaged them to attract other types of investors.
One successful investor diversification strategy focused on the tremendous growth in the number of employers
offering DC pension plans.
The strategy’s primary objective was for a mutual fund company to have some of its current investment mandates
included on the list of approved mutual funds for a company’s DC plan. This represented a somewhat wholesale
approach to individual investors, since the mutual fund company was targeting the employer rather than the
employees. Mutual fund companies are also able to leverage the brand awareness they currently have in the retail
mutual fund market.
The second growth opportunity that a number of mutual fund companies have pursued is the wholesale or standard
institutional marketplace. Some mutual fund companies have been quite successful at positioning their funds as
suitable investments for a number of institutional investors, including trusts, endowments, and small to mid-sized
pension plans. A number of Canadian mutual fund companies have sourced as much as 20% to 25% of their total
assets under management from these traditional institutional investors. In some cases, mutual fund companies
have become formidable competitors to traditional institutional investment managers.

ENDOWMENT FUNDS/TRUSTS
Endowment funds are portfolios that are managed to produce income for a beneficiary organization. They usually
invest in long-term assets and attempt to earn a targeted rate of return, typically in the range of 5% per annum.
This income finances part of the annual operating costs of the beneficiary’s organization.
Endowment funds encompass a broad range of institutions. Among these are religious organizations; educational
institutions; cultural entities, such as museums and symphony orchestras; private social agencies; hospitals;
and corporate and private foundations. Another rapidly growing area of endowment investing is non-profit
organizations, such as trade organizations or public foundations, which often have significant endowment or reserve
assets.
Endowments range in size from a couple of hundred thousand dollars to several billion dollars, depending on the
fund’s age and its success in soliciting contributions. Some of the largest endowments in Canada support post-
secondary educational institutions.

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Although often compared in terms of investment objectives and constraints, endowment funds and retirement
funds have only two major similarities. Both are usually long term in nature and — with few exceptions — are
not taxable. But the differences are far more important than their similarities. The range of an endowment fund’s
objectives is extremely broad and they are often qualitative in nature. For endowment funds and trusts, the
determination of an investment policy can be viewed as a resolution of a creative tension existing between the
highly demanding need for immediate income, and the pervasive and enduring pressures for a growing stream of
future income to meet future needs.
Trusts are very similar to endowments, but they usually have a very “narrow” list of beneficiaries that is typically
limited to family members or other named individuals. It is difficult to obtain any reasonable estimate as to the
size of trust assets, since the majority of trusts are family-structured or private in nature and do not make public
solicitations for contributions.
Endowments and trusts deal with essentially the same issues that most institutional investors face when making
investment management-related decisions. In response to growing demand, many investment managers offer
investment funds that accommodate the investment needs of endowments and trusts. Numerous banks and trust
companies have subsidiaries that specialize in offering both administration services and investment management
services tailored to meet the needs of trusts and endowments.
As is the case with other types of institutional investors, an endowment fund’s current asset size and its projected
growth are major factors that influence a decision as to whether resources should be expended to establish internal
investment management expertise or whether a fund should continue to use third-party investment managers. A
number of years ago, the Board of Trustees of the University of Toronto’s endowment fund decided to create and
develop a team of internal investment managers to manage its assets.

CORPORATE TREASURIES
The management responsibility of a corporation’s financial assets normally resides with its corporate treasury
department. The range of investment management services and activities performed in the treasury department
can vary widely. In the case of small to medium-sized companies operating in only one country or currency, their
investment management responsibilities are essentially focused on cash management activities that support the
company’s liquidity and cash flow needs.
However, at the other extreme, very large multinational companies often have very sophisticated investment
management requirements and, accordingly, have committed substantial resources to their treasury functions.
Some large (non-financial) companies have treasury operations that rival those of a medium-sized investment
dealer.
Although cash management activities still form the heart of treasury operations, large corporations are often
engaged in other specialized investment management activities, such as foreign exchange risk management,
corporate funding and the use of complex derivatives to gain or hedge risk exposures particular to their industry
or company. In the case of industrial or non-financial firms, their treasury and investment management staffs are
required to perform their duties in accordance with operating guidelines and principles that the company’s senior
management establishes and its board of directors approves.
These types of companies, as well as their respective treasury staff, do not require registration with securities
regulators, since none of their investment activities fall under the purview of a securities regulator. Although they
do not require securities registration, many non-financial corporations nonetheless endeavour to incorporate the
appropriate best practices that prevail in the investment management operations of companies, such as investment
dealers or fund companies, that do require securities registration.
For companies that offer a DB pension plan, the corporate treasury department is normally responsible for the
operation of the pension plan’s investment management.

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OTHER INDUSTRY PARTICIPANTS

INVESTMENT CONSULTANTS
In recent years, the importance of investment consultants (also referred to in North America as pension
consultants), who primarily advise institutional asset holders on the choice of external investment managers, has
been on the rise. Traditionally, investment consultants have been of greatest value to smaller pension funds, since
large pension funds have been less inclined to hire external investment managers. Recently, however, as investment
management has increasingly been outsourced, pension fund trustees have lost some of their internal support and
have started to rely more and more on investment consultants.

FUND RATING AGENCIES

Fund rating agencies specialize in providing market participants with information for investment decision-making
by formally scoring the rated company’s “quality.” In terms of generating these scores, fund rating agencies tend to
distinguish themselves by using an approach that is either based on quantitative ranking or qualitative ratings. While
fund rankings try to help investors evaluate pooled investment vehicles based purely on measures of historical
performance, fund ratings seek to evaluate investment funds against their investment philosophy background,
policies and procedures, and fund managers’ track records. With their services targeted mostly at the retail market,
both types of fund raters distinguish themselves from the investment consultants, which concentrate on the
business’s wholesale side.

MARKET INDEX PROVIDERS

Market index providers create and maintain market indexes, which measure the price performance of a hypothetical
investment. Over time, the role of these index providers has become increasingly visible in the asset management
industry. Since market indexes have become the benchmarks to which the performance of asset managers is
compared, they have come to strongly influence the structure of asset managers’ incentives. Conceptually, financial
market indexes are easy to understand and interpret.
Table 3.1 summarizes the key aspects for various types of institutional investors. The table lists the major groups
of institutional investors and compares them on the basis of ownership, management of funds, performance
evaluation and risk profile. One of the most important points of comparison pertains to who actually assumes
investment risk with these different types of investment products. The bearer of residual (investment) risk is
provided in the extreme right-hand column of the table. It is important to note that it is only in the case of DB
pension plans and life insurance products that the beneficiary or the insured, respectively, does not bear the
investment risk. With all other types of institutional investments, either the investor or the beneficiary bears the
investment risk.

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Table 3.1 | Participants in the Institutional Investment Industry and their Activities

Type of Activity/Responsibility

Who has the

Responsibility
for Monitoring
Who is the Beneficial Who manages the and Performance Who Bears the
Type of Investor Owner of the Funds? Capital? Evaluation? Risk?

Pension Funds Pension plan Normally, an external Trustees, consultants Plan sponsor
(Defined Benefit) investment manager

Pension Funds DC beneficiary Normally, an external Trustees, consultants DC beneficiary

(Defined investment manager
Contribution)

Insurance Insurance company Often, an internal Insurance company, Insurance company

Companies investment manager consultants

Mutual Funds Household Typically, an internal Investors, rating Household

(Retail Business) investment manager agencies

Endowments/ Endowment/trust Internal or external Trustees, consultants Beneficiaries

Trusts investment manager

Corporate Corporation Internal investment Corporation Corporation

Treasuries manager

Private Investor Household Household Household, rating Household

agencies

PRINCIPAL-AGENT RELATIONSHIPS IN INVESTMENT MANAGEMENT

At the core of the investment management industry, there is a separation between ownership and the control
of financial wealth. This results in a number of principal-agent relationships within the investment management
industry. Delegated investment management involves a layering of the various agency relationships. Figure 3.1
provides a schematic comparison of the typical principal-agent relationships associated with both individual and
institutional investors.

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 CHAPTER 3 | THE INSTITUTIONAL INVESTOR 3 • 11

Figure 3.1 | Comparison of Individual and Institutional Asset Management Relationships

Individual Institutional

Investor Beneficiary

Sponsor Trustees

Fund Rating Agency/ Consultant/

Index Provider Index Provider

Asset Management Company Asset Management Company

Individual Asset Manager Individual Asset Manager

Capital Markets Capital Markets

The figure starts at the bottom with the source of all investments — the capital markets. In the case of an
individual investor, the overall relationship is very direct, with the asset management company functioning as the
intermediary between the individual investor and the capital markets. Typically, the only other agents involved are
mutual fund rating companies and capital market index providers. The primary role of these two service providers
is to provide independent data and analysis that assist an investor in evaluating the investment management
company’s performance.
The right side of Figure 3.1 depicts the typical principal-agent relationships associated with institutional investors.
There are two notable differences in their relationships compared to those of individual investors. First, a consultant
specializing in hiring and assessing institutional investment managers replaces the fund rating agency. A firm
specializing in servicing endowment and pension plans usually provides this service. Examples of large pension
consulting firms are Aon Hewitt and Willis Towers Watson. Second, the institutional model also involves the
important addition of two separate but related intermediaries. In the case of a private pension plan, the employer
offering the plan is described as the plan sponsor, because it offers the pension plan benefit to its employees.
In addition, an independent committee, usually referred to as a board of trustees, is established to oversee the
pension plan’s operation. A board of trustees is used in numerous types of institutional investment management
relationships, including private pension plans, endowments and family trusts.
It is also important to note that mutual funds established as trusts are also required to have a board of trustees,
which provides oversight to ensure that the mutual fund is operated according to the trust indenture under which it
was established.
In addition, the activities of fund and credit rating agencies, as well as index providers, will directly or indirectly
influence the behaviour of one or more of the other agents. Therefore, they will have a bearing on the relationship
between the ultimate investor and the fund manager. For example, seemingly insubstantial changes to the way a

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benchmark index is measured can have a material impact on index levels and returns. Therefore, once a portfolio’s
benchmark is chosen, index providers influence asset allocation and portfolio returns by deciding on index
composition.
As the number and complexity of principal-agent relationships increase, the likelihood that there will be conflicts
of interest between investors and their agents also increases. In consequence, investment decisions can vary across
funds, partly due to differing numbers and combinations of agency relationships. For example, the investments
chosen by DC pension funds can differ substantially from those in DB plans. In the former, individual employees
investing on their own are making the choices, whereas in the latter, they are guided by corporate treasurers or
pension plan trustees acting for the pension fund’s beneficiaries as a group. In addition, individual customers’
investment decisions might further be influenced by the advice of investment firms’ sales networks, which may
have certain incentives to sell or recommend particular products.

GOVERNANCE

REGULATORY ENVIRONMENT
A number of Canadian securities industry and non-securities industry regulators are involved in the regulation
of domestic institutional investment managers. However, in broad terms, two regulators oversee the majority of
firms and individuals involved in the creation, management, sale and distribution of financial products and services
in Canada:
1. The Office of the Superintendent of Financial Institutions
2. Provincial and territorial securities regulators

The first, the Office of the Superintendent of Financial Institutions (OSFI), is an independent agency of the
Government of Canada that reports to the federal Minister of Finance. The OSFI supports the government’s
objective of “contributing to public confidence in the Canadian financial system,” and according to its official
website, its mandate is to:
• Supervise federally regulated financial institutions and pension plans to determine whether they are in sound
financial condition and meeting regulatory and supervisory requirements;
• Promptly advise financial institutions and pension plans if there are material deficiencies, and take corrective
measures expeditiously, or require management, boards or plan administrators to do so;
• Advance a regulatory framework designed to control and manage risk;
• Monitor and evaluate system-wide or sectoral developments that may negatively impact the financial condition
of federally regulated financial institutions.

Further, the OSFI has “due regard for the need to allow institutions to compete effectively and take reasonable
risks,” recognizing that “management, boards of directors and plan administrators are ultimately responsible for risk
decisions and that financial institutions can fail and pension plans can experience financial difficulties resulting in
loss of benefits.”1
Note that the OSFI is considered to be a non-securities regulator because the principal products offered or managed
by the companies it regulates do not fit the definition of a “security.”

1
Office of the Superintendent of Financial Institutions, “Mandate.” http://www.osfi-bsif.gc.ca/Eng/osfi-bsif/Pages/mnd.aspx

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 CHAPTER 3 | THE INSTITUTIONAL INVESTOR 3 • 13

EXAMPLE
A Canadian bank’s capital and products, such as chequing accounts and term deposits, are not considered
securities. The products that life insurance companies sell and the pension plans that corporate employers offer
are also not considered securities.

The other primary regulators of financial services in Canada are the various provincial and territorial securities
regulators. They are responsible for establishing and enforcing regulations and operational procedures that
support the effective operation of Canada’s securities markets and the proper conduct of its various participants.
Whereas the OSFI operates under a federal government charter and therefore has a nationwide mandate, securities
regulators operate under mandates that their respective provinces and territories grant them.
An example of a Canadian securities regulator is the Ontario Securities Commission (OSC). The OSC’s mandate,
set by statute by the Ontario government, is “to provide protection to investors from unfair, improper or fraudulent
practices and to foster fair and efficient capital markets and confidence in capital markets.”2
The OSC is responsible for establishing and enforcing regulations and operational standards associated with the
creation, management, sale and distribution of securities that are either managed in Ontario or sold to Ontario
residents. Also, in a manner similar to the OSFI, the OSC and other provincial and territorial securities regulators are
responsible for the creation and enforcement of regulations pertaining to the operation of the investment managers
over whom they have regulatory supervision.

INSTITUTIONAL INVESTMENT FUND GOVERNANCE

The governance standards and practices for institutional investment funds are very well established and are based
on concepts and standards, such as the prudent man rule and the concept of fiduciary duty. All institutional funds
have their own clearly defined governance standards and procedures, but for the most part, they operate at very
similar standards. They avoid any deviation from investment industry conventions and best practices, and all
industry participants in institutional investment are keenly aware of the requirements for excellent fund governance.
An institutional investment fund’s governance typically involves the following organizational structure:
• Board of trustees
• Investment committee (and its staff)
• Investment consultant
• Investment manager

BOARD OF TRUSTEES
As mentioned earlier, a fund’s board of trustees is ultimately responsible for all aspects of the fund’s operation. Its
specific roles and responsibilities are clearly established in the fund’s trust indenture or pension plan documents.
With particular regard to the investment aspect of the fund’s operation, the board of trustees will approve the fund’s
investment policy statement (IPS). Typically, in large funds, the IPS is developed by the investment committee for
the fund’s investment program.
The fund’s board of trustees, in its sole discretion, can delegate its decision-making authority to the investment
committee regarding the investment program within the IPS’s established guidelines.
The investment committee will report regularly to the board of trustees on the portfolio’s financial performance and
on significant decisions related to the portfolio’s management.

2
Ontario Securities Commission, “Notice of Statement of Priorities for Financial Year to End March 31, 2017”
http://www.osc.gov.on.ca/documents/en/Securities-Category1/sn_20160609_11-775_sop-end-2017.pdf

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INVESTMENT COMMITTEE DUTIES

Generally, a fund’s board of trustees will create a subcommittee with the specific mandate of focusing on the
investment management aspects of the fund’s operations. The investment committee is normally populated by a
subset of individuals who serve on the board of trustees. In the case of a pension plan, the investment committee
often includes one or more senior executives from the pension plan’s sponsor.
In the management of the fund’s investments, an investment committee discharges its obligations by performing
a number of key duties. For one thing, they prepare a comprehensive IPS that provides the framework for the
management of all of the fund’s investments.
The purpose of an IPS is to document the investment management process by:
1. Identifying the key roles and responsibilities related to the ongoing management of a fund’s assets; and
2. Setting forth an investment structure for a fund’s assets, which includes all of its asset classes and acceptable
ranges that, in aggregate, are expected to produce a sufficient investment return over the long term while
prudently managing risk.

This strategy should provide guidance in all market environments, and should be based on a clear understanding of
worst-case outcomes.
The investment committee also does the following:
• Establishes formalized criteria to measure, monitor and evaluate a fund’s performance results on a regular basis;
• Encourages effective communication among all fiduciaries, including external parties engaged to execute
investment strategies;
• Recommends the hiring and termination of investment managers;
• Monitors an entire fund’s performance and all of the sub-funds that form part of its total assets; and
• Reviews periodic (usually quarterly) reports about the operations and results of the various investment
managers prior to submitting them to the fund’s board of trustees.

STAFF DUTIES
Larger institutional investors often have dedicated internal staff that assist in a fund’s administration and operation.
They are generally responsible for implementing the IPS as directed by the investment committee, which includes
executing any documents necessary to facilitate the IPS’s implementation, including but not limited to contracts
with consultants and investment managers for providing services.
In addition to implementing a fund, the staff also maintain it. They manage the cash flows both into and out of
the fund as a result of investor redemptions or beneficiary payments, review the fund’s investments to ensure that
policy guidelines continue to be met and monitor investment returns on both an absolute basis and relative to
appropriate benchmarks. The information for these reviews comes from outside advisors, the custodian and the
fund’s investment managers.
If the fund needs to be adjusted, the staff will rebalance it in order to maintain the proper diversification within
the ranges the investment committee has approved, and in accordance with its established rebalancing policy. If
problems should arise, the staff will raise timely concerns with the investment committee and take appropriate
action under the investment committee’s direction if investment objectives are not being met or if policies and
guidelines are not being followed.
Administratively, the staff are responsible for recommending a qualified custodian for the fund, as defined by the ability
to handle investments, transactions and strategies that the IPS authorizes. The staff prepare monthly and quarterly
summaries of investment activity and performance for the investment committee. They also monitor each investment
manager overall to ensure that they conform to the terms of their contracts and that their performance monitoring
systems are sufficient to provide the investment committee staff with timely, accurate and useful information.

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 CHAPTER 3 | THE INSTITUTIONAL INVESTOR 3 • 15

INVESTMENT CONSULTANT DUTIES

When retained for service, investment consultants typically perform the following services:
• Assist in establishing a fund’s investment policies, objectives and guidelines.
• Recommend institutional investment managers in accordance with a fund’s IPS and periodically review them.
• Review a fund’s investments at least monthly to ensure that policy guidelines continue to be met.
• Monitor a fund’s investment returns on both an absolute and relative basis to appropriate benchmarks, and
provide reports to the investment committee on a quarterly basis.
• Inform the investment committee regarding any qualitative changes to a fund’s investment management or
strategies, which is generally referred to as investment manager “style drift.”

INVESTMENT MANAGER DUTIES

Among its numerous responsibilities, a fund’s board of trustees is responsible for appointing suitable investment
managers to manage its assets. As mentioned earlier, investment managers can be internal staff or external third-
party investment managers, or both, depending on the fund’s size and particular needs.
Investment managers usually have discretion to develop and execute their investment program within the
constraints set forth in a fund’s IPS. At a minimum, investment managers should comply with applicable laws and
regulations governing their operations, conduct their business and professional affairs in a manner consistent with
their corporate code of conduct and ethics, and know and comply with all of the guidelines and restrictions outlined
in a fund’s IPS. They are also encouraged to identify investment policies or guidelines that may have an adverse
impact on a fund’s performance, and to initiate discussion with the fund’s staff or investment committee toward the
possible modification and improvement of those policies.
Investment managers are also responsible for maintaining thorough and appropriate written risk control policies
and procedures. The oversight of and compliance with these policies must be ongoing and independent of the fund’s
investment activity. They have to reconcile accounting, transaction and asset summary data with the custodian’s
valuations on a monthly basis, and communicate and resolve any significant discrepancies with the custodian. Any
unresolved discrepancies must be promptly reported to the fund’s staff.
Maintaining frequent and open communication with a fund’s staff, as well as with the investment committee,
is imperative. Some of the significant matters pertaining to the IPS that investment managers should be
communicating about are as follows:
• Major changes in investment outlook, investment strategy, investment process, sub-advisors or portfolio
structure.
• Significant changes in ownership, organizational structure, financial condition or senior personnel.
• All pertinent issues deemed to be of significant interest or material importance.

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3 • 16 PORTFOLIO MANAGEMENT TECHNIQUES

SUMMARY
After completing this chapter, you should be able to:
1. Explain the role of financial intermediation in the function and growth of capital markets.
Financial intermediation involves the movement of funds between those who supply capital and those who
use it.

2. Describe the various groups of institutional investors and explain each of their activities.
Pension funds: The two main types of pension funds are defined benefit (DB) and defined contribution (DC).
Insurance companies: Offer products such as annuities and guaranteed investment contracts that are
tailored to the needs of individual and collective pension plans.
Mutual funds: Have become the investment vehicle of choice for many individuals who do not have the time,
inclination or resources to properly research individual stocks and bonds to include in their portfolio.
Endowments/Trusts: Endowment funds are portfolios that are managed to produce income for a beneficiary
organization. Trusts are very similar to endowments, but they usually have a very “narrow” list of
beneficiaries that is typically limited to family members or other named individuals.
Corporate treasuries: Responsible for managing a corporation’s financial assets.

3. Explain the role of other industry participants.

A number of institutional services exist to aid in the selection and assessment of financial intermediaries.
The three key service providers are investment/pension consultants, fund rating agencies and market index
providers.

4. Describe the principal-agent relationship in investment management.

Typically, investment management involves a number of principal-agent relationships. The nature
and number of these relationships vary depending on whether the investor or client is an individual or
institutional investor.

5. Describe the regulatory environment in domestic institutional investment management and the roles of the
Office of the Superintendent of Financial Institutions (OSFI) and Ontario Securities Commission (OSC).
In broad terms, two regulators oversee the majority of firms and individuals involved in the creation,
management, sale and distribution of financial products and services in Canada: The Office of the
Superintendent of Financial Institutions (OSFI) and provincial and territorial securities regulators.
The OSFI is considered to be a non-securities regulator. The OSFI’s mandate is to supervise federally
regulated institutions and pension plans.
The OSC is responsible for establishing and enforcing regulations and operational standards associated with
the creation, management, sale and distribution of securities that are either managed in Ontario or sold to
Ontario residents.

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 CHAPTER 3 | THE INSTITUTIONAL INVESTOR 3 • 17

6. Describe the roles of the board of trustees, investment committee, investment consultant and investment
manager in governing an investment fund.
The governance of an institutional investment fund typically involves the following organizational structure:
« The board of trustees, which is ultimately responsible for all aspects of a fund’s operation.
« The investment committee, which is focused on the investment management aspects of a fund’s
operations. Larger institutional investors often have dedicated internal staff that assist in a fund’s
administration.
« An investment consultant, who typically performs such services as assisting in establishing investment
policies, recommending institutional investment managers and monitoring a fund’s investment returns.
« An institutional investment manager, who usually has the discretion to develop and execute their
investment program within the constraints set forth in a fund’s investment policy statement (IPS).

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 The Investment
Management Firm 4

CONTENT AREAS

Ownership and Compensation Structures

Regulations and Licensing

Organizational Structure

Investor Types

Service Channels

Investment Mandates

Roles and Responsibilities of Institutional Investment Managers

Investment Management Fees

Industry Challenges

Corporate Governance

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LEARNING OBJECTIVES

1 | Describe an investment management firm’s basic ownership structure and explain the differences
between public and privately owned firms.

2 | Describe an institutional investment management firm’s basic organizational structure.

3 | Identify and explain the major types of investors.

4 | Discuss the major investment product structures that institutional investment management firms
manage.

5 | Explain how the types of investment mandates an institutional investment management firm offers
can affect its structure and operations.

6 | Illustrate the primary roles and responsibilities of the various parties involved in the management of
a Canadian mutual fund.

7 | Explain how an investment manager collects fees and identify the various types of fees institutional
investment management firms charge.

8 | Describe the key challenges the institutional investment management industry faces and what
actions are being taken to mitigate these challenges.

9 | Explain the critical role of governance in an institutional investment management firm’s operations.

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

accredited investor non-exempt investors

chief compliance officer (CCO) offering memorandum exemption

corporate governance pooled fund

exempt investors segregated account

exempt market dealers separation of duties principle

general partner sub-advisors

investment dealer trustee

limited partnership (LP) ultimate designated person (UDP)

minimum investment exemption

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 CHAPTER 4 | THE INVESTMENT MANAGEMENT FIRM 4•3

INTRODUCTION
The term institutional investment manager generally refers to investment management firms involved in the
management of pooled investment vehicles. However, the term is also used to refer specifically to firms that focus
solely on managing investments for institutional investors. These particular firms target investment mandates
from institutional investors, such as defined benefit pension plans, endowments, large family trusts and corporate
treasuries.
The business and marketing strategy of most institutional investment management firms is focused on the
accumulation of wholesale investment assets. These firms seldom, if ever, pursue investment management
mandates for investment products, such as mutual funds, that are sold to retail — that is, individual investors — and
for that reason these firms are not familiar household names. Unlike most of the major mutual fund companies
that spend significant resources on advertising and building brand name recognition, most institutional investment
management firms have insignificant advertising budgets since they are not attempting to build brand name
recognition with individual investors.
Institutional investment managers have competition from life insurance companies and mutual fund companies
that pursue the same target investors. These companies have designed investment products specifically for
institutional investors and have created skilled marketing teams that focus on this particular type of investor.
Some of these companies have experienced some success in accumulating assets from institutional investors
and, accordingly, have helped raise the degree of competitiveness in this particular niche market. Institutional
investment management firms usually offer only a limited number of investment mandates.
Historically, institutional investment managers have had mandates that focus on either the Canadian bond or
equity markets. However, many institutional investment management firms have combined their expertise of the
Canadian bond and equity markets, and offer a Canadian balanced fund. For a number of Canadian institutional
investment management firms, a balanced fund is their largest mandate in terms of assets under management.
However, with institutional investors showing an ever-increasing interest in global investment mandates,
institutional investment management firms have to consider whether to commit resources that enable them to
include international securities in their investment funds. Some firms have decided to make this investment, while
others remain stringently focused on domestic financial markets.
The purpose of this chapter is to explore the different aspects of an investment management firm. We begin the
chapter with a discussion of a firm’s ownership and compensation structures, followed by its regulations and
licensing requirements. This chapter also introduces the topic of an investment management firm’s organizational
structure, which will be dealt with in more detail in chapters 5 and 6 of this course. Types of investors, product
structures and investment mandates are covered next, followed by the roles and responsibilities of investment
managers. The chapter ends with a discussion about industry challenges and corporate governance, which all
investment managers need to be aware of.

OWNERSHIP AND COMPENSATION STRUCTURES

Given the types of activities they are usually involved in, all investment management firms in Canada are structured
legally as corporations to be considered for, and receive registration from, the appropriate securities regulator or
regulators. As discussed in a later section of this chapter, appropriate securities registration is required not only for
the firm, but also for certain individuals. However, in addition to being necessary, this corporate ownership structure
offers numerous advantages to a firm’s owners, as follows:
• First, a firm’s owners want the benefits and protection that corporate entities offer. They receive the same tax
and fiscal benefits available to all those who choose to structure their business activities as corporate entities.
Of course, investment management firm owners also receive the benefits of limited liability protection, as
offered by the corporate structure.

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• Second, firms are usually envisioned as long life business ventures, and the corporate vehicle best suits this
objective. Investment management firm founders and owners plan and hope that, over time, their business will
develop a long history of stability and competitive returns for clients, as well as strong growth, both in terms of
the number of clients and the amount of assets under management.
• Third, some owners want to create brand identity in the institutional investor marketplace to aid in their firm’s
growth. A corporate vehicle is often the best way to accomplish this goal. Strong brand identity may also
minimize the impact to the firm if one or more of its senior portfolio managers should depart. The loss of a key
employee is often a considerable risk in the institutional investment management industry, particularly for
smaller firms. Strong brand identity attracts skilled personnel.
• Fourth, corporate share ownership is an incentive that attracts and retains key productive staff. Over time,
significant personal wealth can accrue for a successful institutional investment management firm’s owners as
the firm benefits from considerable economies of scale and the accompanying profitability.

PRIVATELY OWNED STRUCTURE

The vast majority of Canadian investment management firms are privately owned. Private ownership generally
takes one of two major forms: either 100% employee-owned or employee majority–owned with a passive external
owner.
Small to medium-sized firms are usually private corporations, with active staff members holding all of their shares.
This structure is typical for all investment management firms during their start-up phase, and also for those larger
privately owned firms that have striven to operate in an independent fashion and prefer a partnership-type business
relationship. By their nature, institutional investment management firms are not typically capital intensive and can
be funded at start-up by one or more individuals who want to operate in a private corporation on a partnership
basis.
If successful, these privately owned firms can generate more than sufficient profits to fund their planned growth and
therefore do not generally require any external capital to expand their operations over time. Figure 4.1 below depicts
the typical ownership structure for both privately owned investment management firms at start-up and larger
privately owned investment management firms that essentially operate as partnerships.

Figure 4.1 | Privately Owned Institutional Investment Management Firm

Director/Officer A Director/Officer B Director/Officer N

Investment
Management Firm
(Corporation)

Most privately owned investment management firms continue to operate as partnerships, with all of the firm’s
shareholders involved in its daily active management.
However, over time, some medium- to large-sized individually owned firms may slightly change their share
ownership structure to accommodate an investment by an institutional investor. When it occurs, this change in
the firm’s ownership is normally limited to one institutional investor whose original investment is always limited
to a minority voting position in the firm and often starts with a modest 10% to 15% of its voting equity. Figure 4.2
depicts this type of shareholder arrangement.

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 CHAPTER 4 | THE INVESTMENT MANAGEMENT FIRM 4•5

Figure 4.2 | Privately Owned Institutional Investment Management Firm with a Passive Institutional
Investor

Director/Officer A Director/Officer B Director/Officer N Institutional Investor

Investment
Management Firm
(Corporation)

These transactions are essentially win-win situations. A firm enters into this arrangement because it will benefit
from the sales and distribution capabilities that the institutional investor already has in place, which can be used to
accelerate the growth rate of the firm’s assets under management. An institutional investor enters into this type of
transaction because it might not have the specific investment skills that a smaller firm can provide.
Essentially, in this instance, the institutional investor has decided that it would take an unacceptably long period
of time to build an internal investment management team with skills comparable to those of the investment
management firm, while the firm has concluded it can grow its business at a much faster rate and with less time
and capital by using the institutional investor’s resources. Each party faces the risk that without this type of business
arrangement, it might not be able to maximize its potential.
After selling its minority stake, the institutional investment management firm’s investment strategy is then quickly
repackaged into financial products that meet the needs of a financial institution’s current investor mix. Also, under
typical contractual terms, the institutional investment management firm is restricted from offering its investment
services and products to those firms the institutional investor deems competitors.

PUBLICLY OWNED STRUCTURE

Strictly speaking, from a legal perspective, there are no publicly owned investment management firms. All publicly
owned financial institutions consolidate their investment management personnel and operations within one or
more companies established specifically for that purpose. These companies are usually organized as wholly owned
subsidiaries of holding companies that are publicly owned. Figure 4.3 depicts the typical corporate ownership
structure for publicly owned financial institutions, such as mutual fund companies, life insurance companies, banks
and investment dealers, and their investment management subsidiaries.

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4•6 PORTFOLIO MANAGEMENT TECHNIQUES

Figure 4.3 | Institutionally Owned Investment Management Firm

Parent or
Holding Company
(Public Traded)

Portfolio Manager
100% Owned by
Mutual Fund Dealer and/or
Parent Company
Exempt Market Dealer

It should be noted that there have been a limited number of investment management firms that have been able to
successfully float their company stock on public stock exchanges. These companies have not been the traditional
long-only investment managers, but rather institutional investment managers that offer hedge funds and other
alternative investment vehicles, such as private equity and real estate–based investments.

COMPENSATION STRUCTURES
Compensation structures for institutional investment managers are typically comprised of some combination of the
following four types of benefits:
1. Base salary
2. Annual cash bonus
3. Shares (real or notional) or share purchase options, or both
4. Profit sharing

Actual compensation structures for institutional investment managers vary from firm to firm, but the amount of
total compensation is in direct proportion to such factors as:
• An individual’s level of investment management responsibility
• A portfolio’s performance
• An individual’s success at growing the firm’s client base and accumulating additional assets to manage
• An individual’s tenure with the firm
• A firm’s ownership structure (private or a wholly owned subsidiary of a public company)
• A firm’s overall financial success

BASE SALARY
Virtually all Canadian institutional investment managers receive a base salary as part of their compensation.
Salaries are based primarily on an individual’s level of investment management responsibility, including the role
they perform, such as investment analyst, assistant portfolio manager, portfolio manager or chief investment
officer, with their tenure in the industry as the second-most heavily weighted factor.

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CASH BONUS
An annual cash bonus is also fairly common in the institutional investment management industry. Annual cash
bonuses are normally set for each investment manager at a target amount, which is usually expressed as a
percentage of the portfolio manager’s base salary.
Table 4.1 provides the typical range of target cash bonus amounts (as a percentage of the base salary) for increasing
levels of portfolio management responsibility. The actual cash bonus payout is determined on the basis of how
successful the employee was at attaining the specific goals used in establishing their cash bonus targets.

Table 4.1 | Typical Range of Cash Bonuses for Institutional Investment Managers

Role Bonus (Percentage of Base Salary)

Analyst 25% to 50%
Assistant Portfolio Manager 50% to 100%
Portfolio Manager 100% to 150%
Chief Investment Officer 100% to 200%

The performance of the various portfolios under a portfolio manager’s responsibility is by far the major determinant
of cash bonus payments. The primary measurement of a portfolio’s performance is usually not its absolute rate of
return, but rather its percentile or quartile ranking in a representative universe of competitors’ portfolios with the
same investment mandate.
Another factor often considered in determining a portfolio manager’s cash bonus payment is their success at
marketing and attracting new assets for their firm to manage. Many institutional investment management firms
make it a priority to have senior portfolio managers be an integral part of a firm’s client service and marketing
activities, especially since many small and medium-sized firms do not have dedicated marketing and client service
staff. The firm develops a formula in advance to relate the amount of cash bonus to the dollar value of new assets an
individual portfolio manager has been able to source for the firm to manage.

PROFIT SHARING
Profit sharing is the payout of a certain percentage of an institutional investment management firm’s profits to
selected portfolio management staff. When a number of individuals share ownership of a firm, the payout of its
profits is calculated in direct proportion to the amount of equity each individual holds.
Of course, this particular calculation cannot be applied if a firm is a wholly owned subsidiary of a publicly traded
(or another privately owned) firm, since none of the employees own any actual shares in the institutional
investment management firm. In this case, the most senior portfolio managers typically own phantom shares in the
institutional investment management subsidiary.
Phantom equity does not carry votes, unlike actual equity shares, nor does it have any terminal value that can be
realized in the sale of actual equity. However, a program is often created whereby each eligible portfolio manager
receives a certain prearranged percentage of the institutional investment management firm’s profits. In the
aggregate, these managers do not have a claim to all of the investment management subsidiary’s profits, because
the actual owner also receives a set percentage of its profits — often more than 50%.
Sometimes, equity options in a publicly traded parent company are granted to selected portfolio managers in lieu
of phantom equity in a wholly owned institutional investment management firm. This arrangement provides some
opportunity for long-term capital growth for portfolio managers, since phantom equity does not carry any market
value and therefore does not offer any form of long-term financial incentive to portfolio managers.

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REGULATIONS AND LICENSING

The provincial and territorial securities commissions are responsible for the Canadian institutional investment
management industry’s regulatory supervision. In order to offer institutional investment management services and
products in Canada, an institutional investment management firm’s senior staff and the firm itself must hold the
appropriate securities registration.
Securities registrations and licences are required in each province where the institutional investment manager’s
targeted investors reside.

EXAMPLE
If an institutional investment management firm only markets its services and products in the Province of Ontario,
then securities registrations are only required from the Ontario Securities Commission.

Generally, institutional investment management firms that are in their infancy or still relatively small will be
registered in only one or two provinces. Larger institutional investment management firms may have security
registrations and licences in almost every province.

INDIVIDUAL REGISTRANTS VERSUS CORPORATE REGISTRANTS

There are a couple of reasons why institutional investment management firms require licences at two levels — one
licence for the firm itself, and one for certain individuals it employs — in order to engage in this type of business
activity.
First, institutional investment management firms must structure their business affairs in a corporate entity.
Although, in reality, it is the specific investment-related skills and abilities of individual portfolio managers that
are being offered to investors, it is the investment management firm — the legal entity — that is actually offering
portfolio management services to investors. The firm charges investors fees for its services and, like all companies,
assumes the liabilities and pays the expenses associated with operating the firm. With specific regard to liabilities,
the investment management firm is the entity exposed to potential claims and litigation from its investors, which
is why it must obtain and maintain suitable insurance coverage as part of its registration requirements. Under this
type of insurance arrangement, any successful claims against the institutional investment management firm are
paid by the insurance company that provides coverage.
Second, the requisite investment management and business skills reside, of course, with the individual portfolio
managers, not the company. Accordingly, registration is required for the portfolio managers who have the
appropriate skills and qualifications.

Exhibit 4.1 | Trends in Direct Access Electronic Trading

Until about 10 years ago, institutional investment management firms were required to place their security
transaction orders with registered investment dealers. They needed to do so because the investment dealers had
access to the various global stock exchanges of which they were members. Since they were not registered as
investment dealers, institutional investment management firms did not have direct access to these stock exchanges.
A portfolio manager would communicate (usually verbally) his security transaction orders to the institutional sales
staff at the various investment dealers with which his firm had a relationship. In essence, placing these equity trades
created a link in a chain of relationships between the institutional investment manager, the investment dealer and,
finally, the particular stock exchange.

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Exhibit 4.1 | Trends in Direct Access Electronic Trading

Over the years, as a result of continued improvements in encryption and other security-related aspects of electronic
commerce, a number of investment dealers decided to port their direct access to stock exchanges through to some
of their institutional investment management firm clients. In practical terms, the firm that is granted this trading
access has real-time data delivered to its desktop from the stock exchanges the investment dealer has permission to
trade on.
Institutional investment managers enter their buy and sell orders directly to this trading platform. The trades then
go through a unique trading compliance filter that the investment dealer and the respective institutional investment
manager have agreed to. Provided the trade entered by the institutional investment manager conforms to the
various specifications agreed upon, it is then immediately directed to the particular stock exchange where the
transaction will take place.
The compliance filter is critical to the proper functioning of this direct trading platform since it is the risk control
tool established to protect the investment dealer and the institutional investment manager. The most common
compliance parameters are the number of shares and the order’s total market value. Often, both parameters are
used, but the trigger is always set at the lower of the two values. These two parameters are used to accommodate
the fact that the share prices change over time.
This platform has two primary benefits. First, there is less chance for errors in trade execution to occur, because
verbal orders that are normally communicated over the telephone have been replaced with electronic directions.
Second, cost savings from this type of system, as compared to telephone orders, accrue to the investment dealer.
This is the case because the investment dealer’s institutional equity sales personnel are relieved from spending time
on the telephone as go-betweens, essentially just repeating clients’ orders to its trading staff, who then place the
orders with the appropriate stock exchange.
The rise in the number of investment dealers and institutional managers that are adopting this type of trading
system for at least a portion of their equity trading needs has led some to advocate for more regulatory oversight
of this practice. Before, direct access to the world’s stock exchanges was restricted to registered investment dealers
and others who had a stock exchange’s permission. In essence, this new type of trading relationship has resulted
in a potential blurring of the roles and responsibilities for both investment dealers and institutional investment
managers. This system places institutional investment managers virtually on par with investment dealers in regard
to stock exchange access.

ORGANIZATIONAL STRUCTURE
Good organizational structure design is important to all types of companies and certainly to institutional
investment management firms that manage wealth on behalf of their clients. A sound and suitable organizational
structure is the first step toward ensuring that a firm functions at or above industry standards, and allows a firm to
properly implement good business practices, controls and procedures. A firm’s organizational structure should be
reviewed over time and modified as required.
Figure 4.4 depicts a typical organizational structure for an institutional investment management firm. Like many
companies, its structure tends to be organized along functional lines. Figure 4.4 depicts an investment management
firm in its most robust form. It provides a visual representation of the key duties and activities that a firm must
perform in order to conduct its affairs appropriately. This organizational chart would be typical of medium-sized
and large institutional investment management firms that are privately owned and not part of a larger financial
institution.

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Figure 4.4 | Organizational Structure of a Typical Institutional Investment Management Firm

President

Trade
Investment Marketing Compliance Accounting
Settlement

Legal

Audit

There are a number of instances where an institutional investment management firm’s organizational chart could
vary significantly from the structure outlined in Figure 4.4. For example, a very small firm with only two or three
partners would not normally have a sales and marketing department. The partners would share the sales and
marketing responsibilities in addition to performing their respective portfolio management duties.
However, other instances where the institutional investment management firm’s organizational chart does not
include a sales and marketing department are ones in which the firm is a wholly owned subsidiary of a mutual fund
or life insurance company. In these two situations, it is fairly common for the sales and marketing resources that are
responsible for the distribution of the institutional investment management firm’s funds to be part of the parent
company’s sales and marketing department.

FRONT, MIDDLE AND BACK OFFICES

In an institutional investment management firm, the subgroups of the departments depicted in Figure 4.4 are
usually consolidated. This consolidation occurs in three organizational groups expressed as the front, middle and
back offices, as shown in Figure 4.5.

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Figure 4.5 | An Institutional Investment Management Firm’s Front, Middle and Back Offices

President

Trade
Investment Marketing Compliance Accounting
Settlement

Legal
Legend:
Front Office
Middle Office
Audit Back Office

The front office usually includes all staff functions pertaining directly to the firm’s portfolio management activities.
Accordingly, all portfolio management, analyst and trading staff would be part of the front office. Sales and
marketing staff are often also included in the front office. The middle office provides functions that are critical to
the efficient operation of the entire firm. The types of duties middle office staff perform have to do with compliance,
accounting, audits and legalities. They are responsible for ensuring that the firm’s products and services are
designed and delivered in accordance with industry best practices and pertinent regulations. Finally, the back office
generally involves those functions related to the efficient settlement of all of the firm’s security transactions. The
responsibilities, objectives and best practices of the employees in each of these categories will be further explored in
Chapters 5 and 6.

Exhibit 4.2 | Separation of Duties Principle

The separation of duties principle is incorporated into an organizational structure to minimize the potential for
employee self-dealing via collusion with another individual in the firm. Ideally, this principle should be incorporated
into the design of all organizations, and institutional investment management firms are no exception.
For example, investment fund accounting and performance measurement should not be done by any of the
portfolio managers or their staff who are executing trades on a fund’s behalf, or by the back office staff who are
responsible for ensuring that trades settle properly. This is why fund accounting activities are part of the middle
office and are not performed by, nor reported to, front or back office staff.
Similarly, portfolio performance measurement should be performed by middle office staff, not front office staff.
Independence between portfolio management and middle office staff in calculating portfolio rates of return is an
example of where a separation of duties is critical.

Most institutional investors actually take this principle even one step further. They receive portfolio holdings and
return information from their institutional investment manager and compare it to the security holdings and rates
of return information provided by their third-party custodian. In this case, the institutional investor is not relying on
portfolio holdings or rates of return information from any one organization, but is comparing the information from
two independent third-party service providers — its institutional investment management firm and its custodian.
This step provides another way of verifying the accuracy of the records.

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ULTIMATE DESIGNATED PERSON AND CHIEF COMPLIANCE OFFICER

Figure 4.6 also provides a typical organizational chart for an institutional investment management firm, but this
time it displays the reporting responsibilities of each individual role.

Figure 4.6 | An Institutional Investment Management Firm’s Reporting Structure

President
(UDP)

Chief Investment Chief Compliance Head of Head of Head of

Officer (CIO) Officer (CCO) Marketing Legal/Audit Administration

UDP: Ultimate designated person

CCO: Chief compliance officer

Notes: 1. UDP and CCO must be registered in this specific company.

2. Only one UDP and CCO are allowed per exempt market dealer.
3. UDP and CCO designations can be held by the same person.

It is important to note that from a regulatory perspective, there are two specific positions of critical importance:
1. The ultimate designated person (UDP)
2. The chief compliance officer (CCO)

The ultimate designated person (UDP) is responsible to the self-regulatory organizations for the firm’s conduct
and the supervision of its employees. The chief compliance officer (CCO) is responsible for designing and
implementing a supervision system that will provide the firm’s board of directors with reasonable assurance that
compliance standards are being met.
Securities regulators specifically define the roles and responsibilities for UDPs and CCOs. Both of these positions are
named, meaning that all exempt market dealers (EMDs) must register a specific qualified individual for each of these
positions in order to apply for and maintain an EMD registration.
Although it is considered a best practice — and consistent with the separation of duties principle — that different
individuals should hold these two positions, it is possible that they be held concurrently by the same individual. This
would be acceptable in the case of very small institutional investment management firms, but would be frowned
upon for medium-sized and large firms.

INVESTOR TYPES
In designing a firm’s structure and staffing requirements, a portfolio manager needs to consider the types of clients
or investors the firm is planning to service. Catering to different types of investors requires different skills, both at
the initial marketing stage and later at the client support stage.
Institutional investment management firms must incorporate these different investor needs and ensure they
have the proper resources to effectively grow and accommodate different investor types. There are two types of
investors: non-exempt and exempt. Non-exempt investors, such as mutual fund investors, are individuals (retail).
Exempt investors may be either institutions or individuals.

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NON-EXEMPT INVESTORS
Small individual retail investors are commonly referred to as non-exempt investors. Non-exempt refers to the
fact that investment dealers must sell securities to these investors via a prospectus, which discloses a fund’s full
information, including its background and essential data about its securities.

EXAMPLE
A prospectus is prepared when XYZ Mutual Funds would like to add a new Canadian equity mutual fund to its
family of mutual funds.

According to securities regulations, these types of distributions to non-exempt investors can only be made by
appropriately licensed staff employed by registered investment dealers. As noted earlier, an investment dealer is
required to determine the suitability of an investment for each investor. The dealer must undertake a Know Your
Client analysis to help protect small individual retail investors by ensuring that recommended investments are
deemed appropriate for each individual investor.
Although all mutual funds sold in Canada must have an investment advisor registered as a portfolio manager, a
portfolio manager/EMD is not permitted to market or distribute a mutual fund. A mutual fund’s distribution is only
done by an investment advisor with an appropriate licence to sell mutual funds to retail investors.

EXEMPT INVESTORS
Securities regulators do permit the sale of securities without a prospectus, but only under certain conditions and to
investors who meet certain qualifications, known as exempt investors. This is commonly referred to as an exempt
distribution into the exempt market. The exempt market is comprised of both institutional and individual investors.
Securities regulators allow the following three common prospectus exemptions:
• Accredited investor exemption
• Minimum investment exemption
• Offering memorandum exemption

ACCREDITED INVESTOR EXEMPTION

Securities commissions apply different criteria to institutional and individual investors for qualification as
accredited investors, as follows:

Institutional Generally includes entities such as pension funds, trust companies and corporations with
net assets of at least $5 million.

Individual Alone (or with a spouse) has financial assets with an aggregate realizable value (before
taxes, but net of related liabilities) exceeding $1 million, or net income before taxes
exceeding $200,000 (or $300,000, if combined with spouse) in each of the two most
recent years, and a reasonable expectation of exceeding that same income in the
current year.

Investors applying for the exemption must certify in writing that they meet the qualifications required by securities
regulators.

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MINIMUM INVESTMENT EXEMPTION

The minimum investment exemption allows the sale of securities to investors who make a prescribed minimum
investment. National Instrument (NI) 45-106 sets this minimum investment at $150,000 across all jurisdictions in
Canada.

OFFERING MEMORANDUM EXEMPTION

The offering memorandum exemption, which is available in all jurisdictions, waives the requirement for a security
or fund to be distributed with a prospectus. This particular exemption is applied in many jurisdictions with the
concept of an eligible investor. An eligible investor has a lower financial threshold than an accredited investor but
requires a confirmation of suitability from an eligibility advisor who is a registered investment dealer.

INVESTOR-FIRM INTERACTION
The interaction between investors and institutional investment management firms varies depending primarily on
the type of investor and on the amount of assets the firm is managing on a particular client’s behalf.
In the case of very small institutional investment management firms, most, if not all, of the firm’s portfolio
managers will be responsible for servicing its current investors. These firms attempt to match certain investors
with particular portfolio managers, so that the manager can build a rapport with an investor and strengthen their
relationship over time.
In medium- to large-sized institutional investment management firms, a dedicated marketing and client service
staff is often established and resourced in order to provide most or even all of the investor servicing support.
Assuming the client service staff have the appropriate skills and abilities, as well as good internal interaction and
communication with the portfolio management staff, then the majority of written and in-person communications
with investors can be performed by senior members of the client service staff.

MUTUAL FUND INVESTORS

When an institutional investment management firm acts as an advisor (or a sub-advisor) to a mutual fund, there
is only limited communication with the mutual fund’s investors. Typically, a mutual fund’s institutional investment
manager (or portfolio manager) will participate and present at roadshows sponsored by the fund’s manager when
they are launching new mutual funds. The manager uses these presentations to introduce to distributors the
individual portfolio managers who will be managing the new funds. Normally, these roadshows are not open to the
general public and attendance is by invitation only and restricted to those individuals who are licensed to distribute
mutual funds.
It is standard for a mutual fund’s portfolio manager to prepare written quarterly reports for investors. These reports
contain information regarding a specific fund’s periodic rate of return and a short analysis of its performance
relative to its performance benchmark, as well as a brief summary of the investment manager’s outlook for capital
markets and the fund’s positioning relative to that outlook. Beyond this, there is very limited communication
between a mutual fund’s portfolio manager and its investors.
Typically, a mutual fund’s portfolio manager does not communicate directly with its investors — only through the
fund’s manager. All written communications with a mutual fund’s investors come from its manager, rather than
from its portfolio manager. The fund’s manager is licensed to distribute the mutual fund and is therefore the primary
contact with its investors.

INSTITUTIONAL INVESTORS
Institutional investors usually include specific client service requirements when they enter into an investment
management agreement with an institutional investment management firm. Typically, an agreement states that the
manager will prepare detailed portfolio performance reviews and distribute them to its institutional investors on a
quarterly basis. The portfolio manager is typically asked to attend and present an investment management report at

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the institutional investor’s quarterly investment committee meetings, where they explain the investment strategy’s
performance during the previous quarter, their outlook for capital markets, the overall investment strategy and
the portfolio’s positioning for upcoming quarters. The client’s investment committee members also take this
opportunity to ask the portfolio manager questions.
If the relationship is relatively new, the investment manager might be expected to present every quarter for the
first year or so. After the first year, assuming the portfolio’s performance is acceptable and within expectations,
and there are no servicing issues, the portfolio manager would likely be requested to present to the investment
committee less frequently, perhaps on a semi-annual or even annual basis.
Most institutional investors require that an institutional investment manager provide them with a monthly
statement of portfolio holdings, security transactions and rates of return. Institutional investors use these monthly
reports to prepare intra-quarterly reports for their management personnel.

HIGH-NET-WORTH INVESTORS
High-net-worth clients usually meet with their investment managers in person on a semi-annual or annual basis.
The frequency of these meetings is primarily influenced by the size of a client’s portfolio with the institutional
investment manager. High-net-worth clients normally receive portfolio management reports and portfolio holdings
reports on a quarterly or semi-annual basis.

SERVICE CHANNELS
Institutional investment management firms offer their services through different channels that are tailored to the
needs of different investors. Business convention and the unique features associated with each type of channel
are the primary motives for deciding which particular channel to use. An investment strategy does not generally
influence the choice of product structure. Some investment managers will offer the identical investment program
and strategy through multiple channels. Figure 4.7 depicts the relationship between the institutional investment
manager, the client type and the standard investment channel used in each case.

Figure 4.7 | Product Structures by Client Type

Institutional Investment Manager

(Portfolio Manager/EMD)

Institutional Investor Mutual Fund Individual

(non-mutual fund) Sponsor Investor

Exempt/Accredited Investment Sub-Advisory Exempt/Accredited

Institutional Investor Capacity Individual Investor
(Pooled Fund) (Open-Ended Trust with (Pooled Fund)
(Segregated Account) Prospectus) (Segregated Account)
(Limited Partnership) (Limited Partnership)

Whatever channel is used, it is an industry best practice to have a written investment management agreement
between the institutional investment management firm and the investor. An investment management agreement

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documents all aspects of the services the institutional investment management firm will provide and its relationship
with the investor.
In Canada, institutional investment managers offer their services by way of four main channels, as follows:
• Pooled funds
• Segregated/managed accounts
• Limited partnerships
• Sub-advisory capacity

POOLED FUNDS
In terms of assets under management, pooled funds are the largest of the four main product structures that
Canadian institutional investment managers use. A pooled fund is an open-ended trust in which investors
contribute funds that an institutional investment manager then invests or manages. A pooled fund operates like
a mutual fund, but under securities law, it is not required to have a prospectus. Trust companies, investment
management firms, insurance companies and other organizations offer pooled funds. They are legally separate
entities from investment management firms.
Small to medium-sized institutional investors and also high-net-worth individuals who can satisfy the minimum
investment criteria often prefer pooled funds. Virtually all Canadian institutional investment managers that cater to
institutional investors offer pooled funds.
For administrative ease, institutional investment managers prefer to limit the number of pooled funds they offer
and manage. A typical Canadian institutional investment management firm might offer as few as three pooled
funds. One pool would typically offer the firm’s equity mandate, a second pool would offer its fixed income
mandate and the third pool would offer its balanced fund mandate. To make operations even simpler, the third
pooled fund (balanced mandate) often only holds a fixed percentage of its value in units of the other two pools —
the equity pooled fund and the fixed income pooled fund. Changing the balanced fund’s asset mix weighting can be
done very easily by simply selling units in the overweighted pool and buying an equivalent amount of units in the
underweighted pool.
From an administrative perspective, pooled funds are simple to operate since all of its security holdings are held
in and all of its security transactions are settled in one fund or trust. The other key administrative responsibility is
unitholder record-keeping, which keeps a record of each institutional investor’s respective proportional interest in
the pooled fund trust.

SEGREGATED/MANAGED ACCOUNTS
A segregated account is essentially an investment account that is owned by an institutional investor and managed
by a third-party portfolio manager. This is in contrast to mutual funds, wherein an investor’s assets are commingled
with the assets of other investors. It is important to note that for individual investors, this product structure is called
a managed account.
Both institutional and high-net-worth investors use segregated accounts. They generally have higher administrative
fees than pooled funds.
Investors prefer segregated account structures over pooled fund structures for two primary reasons, as follows:
• First, for safety reasons, certain investors stipulate that their assets remain with the custodian of their choice.
When investing in pooled funds, an investor’s money is transferred from their current custodian or banking
institution to either the institutional investment manager itself or to the custodian of the pooled fund. In either
case, the investor’s money is leaving the control of the institution where their assets are presently maintained.

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• Second, segregated accounts are the preferred investment vehicle for personalized investment portfolios
tailored to an investor’s specific needs.
A segregated account is often a feasible solution in a situation where an investor wants to use the institutional
investment manager, but is unable to accept the current investment guidelines and restrictions applying to the
manager’s pooled funds.

LIMITED PARTNERSHIPS
Institutional investment managers often use limited partnership (LPs) as product offerings. They are also
commonly offered to individual investors. An LP is a common form of business organization, with one or more
general partners who manage the business and assume legal debts and obligations, and one or more limited
partners who are liable only to the extent of their investment. Though unit trusts and LPs employ the same
investment strategy, the latter offer features, such as tax-loss selling to reduce a specific client’s tax liabilities, that
both institutional and individual investors prefer over the features of a unit trust. In particular, some investors place
high value on the limited liability aspect afforded to them when they make investments as a limited partner. For
certain investors, an LP investment may also offer tax-related advantages over a unit trust investment.
LPs have been used for well over 100 years in the institutional and high-net-worth investor markets, but they
constitute a relatively small proportion of the product structures used. They are used more extensively in the hedge
fund and alternative investment marketplace.

SUB-ADVISORY CAPACITY
The vast majority of mutual funds are structured as open-ended unit trusts, with a very small number structured
as corporations. In the case of a Canadian mutual fund, through an investment management services agreement
with the mutual fund manager, the portfolio manager delivers specific investment management services to the
mutual fund. The portfolio manager is not responsible for, or involved in, other duties related to the mutual fund’s
operation, such as marketing or performance measurement.

INVESTMENT MANDATES
It is important for a portfolio manager to understand what impact the type and range of investment mandates
offered can have on a firm’s structure and operations. The structural and operational aspects of an institutional
investment management firm can change, often substantially, when foreign market investment mandates or new
product structures, such as hedge funds, are added to its product offerings.
It is often quite easy for an institutional investment management firm to underestimate the additional operational
requirements and risks associated with investing outside of national borders. This section looks at the major
investment mandate considerations that Canadian institutional investment management firms face, and discusses
the unique structural and operational adjustments that are an integral part of these new investment mandates.

DOMESTIC SINGLE-SECTOR MANDATES AND BALANCED FUNDS

Domestic investment mandates, including money market, fixed income, equities and balanced funds, constitute the
basic investment product platform for the majority of Canadian institutional investment management firms. Most
medium-sized and large firms organize their portfolio managers in alignment with the primary market for which
they are responsible.
For a number of institutional investment management firms, balanced fund mandates are becoming increasingly
popular and presently constitute a significant portion of their total assets under management. The fixed income and
equity portions of a firm’s balanced fund products are managed by their respective departments. The decision as to

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what proportion of a balanced fund’s assets is invested in fixed income versus equities is usually determined by a
firm’s asset mix committee, which meets on a scheduled basis throughout the year (normally quarterly) to review
and adjust the target weighting for the two primary asset classes. The asset mix committee is usually made up of
the following individuals:
• Chief investment officer (Chair)
• Head of fixed income
• Head of equities
• Chief economist

SPECIALTY- OR SECTOR-FOCUSED MANDATES

The second most popular type of investment mandate is usually referred to as the specialty- or sector-focused
mandate. However, when measured in terms of assets under management, this mandate is a distant second to the
single-sector mandate discussed above. Most institutional investment management firms do not offer these types
of specialty funds, so that they can remain focused on their single-sector and balanced mandates. In addition, many
firms believe the potential market opportunity is not big enough for them to commit additional resources to fund
specialty mandates.
When offered, the specialty and sector-focused mandates tend to be managed by a mutual fund company’s internal
investment management department. There are only a very small number of institutional investment management
firms that have built their entire business platform around only managing specialty or sector-focused mandates.
The largest share of assets in the specialty and sector arena belong to industry-focused funds. Over time, the
number of specialty funds has proliferated as certain industries or economic sectors have gained prominence in the
economy.

EXAMPLE
During the past 15 years, there has been significant growth in the number of mutual funds that have single
sector–focused mandates based on industries such as biotechnology, the Internet, real estate (and real estate
investment trusts), agriculture and alternative energy sources, just to name a few.

These particular types of investment fund mandates are popular, primarily with individual investors. Medium- to
large-sized institutional investors tend not to invest in specialty or sector-focused investment funds.
Rightly or otherwise, sector-focused funds are often considered as flavour of the week-type mandates. Many
mutual fund managers have a collection of specialty-focused funds that had a brief moment of interest and
investor enthusiasm, only to eventually see investor cash inflows grind to a halt when the particular sector began
to underperform. In the mutual fund industry, these portfolios are often referred to as legacy products. However,
this part of the institutional investment management industry is unquestionably dynamic and will likely continue to
grow.
As most of these mandates are equity market–based, the primary operational change involves hiring portfolio
management staff to manage these particular mandates. Of course, this decision is based on the amount of assets
under management that an institutional investment management firm believes it can accumulate over time. All
other operational aspects are identical to single-sector mandates.

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DID YOU KNOW?

Socially Responsible Investing

Socially responsible investing, commonly referred to as SRI or ethical investing, is a specialty-focused
equity investment mandate that has increased in popularity over the past decade.
Historically, SRI is synonymous with investment mandates that specifically avoided tobacco production,
weapons manufacturing, gambling and alcohol production. However, its investment mandate has
expanded and adapted over time. Each fund manager has their own specific definition of SRI as it applies
to their funds. In general, SRI involves one or more of the following aspects:
• Environmental, low-carbon, sustainable and/or green investing
• Employee’s rights, human rights, religious beliefs
• Community investing (targets specific geographic areas or communities that are severely
underserviced by traditional financial services companies)
• Shareholder advocacy (corporate governance related)

The recent growth of SRI funds and their assets under management has been dramatic. As of 2016,
according to the Responsible Investing Association, there was more than $1.5 trillion in assets under
management in Canadian SRI-related funds. This was a 49% increase in assets under management over a
two-year period. The increase in SRI-related fund investments also occurred in other western markets.
While SRI fund offerings originally began with mutual funds, their structure and type have expanded to
include exchange-traded funds (ETFs), pooled funds and investments by both private and public pension
plans.

STYLE-FOCUSED MANDATES
Although all institutional investment managers have unique investment skills and capabilities, they tend to
categorize their investment strategy as falling into one of the following five popular styles:
1. Growth
2. Value
3. Growth at a reasonable price (GARP)
4. Momentum (or sector rotation)
5. Technically based

Institutional investment management firms use investment strategy styles to describe (and differentiate) their
approach to security selection and other investment decisions. Firms are very careful in terms of communicating
which investment strategy style they use. They will endeavour to approach all of their various investment mandates
by using the same style, with only very little modification, depending on the specific mandate. They want to be
careful to send only one marketing message to current and potential investors. Firms also tend to stick with one
style over time, since the decision to change investment management styles is often met with scepticism by
investors.
None of these style mandates requires any specific changes to the firm’s structure or operations from the single-
sector or balanced mandates.

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PASSIVE INVESTMENT MANAGEMENT

Over the past 10 years, the annual growth rate of assets under management for passive investment products has
surpassed that of actively managed products — and sometimes by a wide margin. According to Morningstar, Inc.,
assets under management in passively managed mutual funds grew 230% globally to US$6 trillion. This compares
to assets held in actively managed funds, where portfolio managers try to beat the market, which grew 54% to
US$24 trillion.
There appears to be no slowdown in this trend as more and more individual and institutional investors either
allocate fresh investable cash or sell actively managed products and invest the proceeds in passively managed
investment products.
The trend has been so profound that by 2018, most North American mutual fund companies launched internally
managed passive investment products, index funds and/or ETFs as a defensive business strategy to help prevent the
continued redemption and loss of valuable long-term investor assets to passively managed investment products
offered by competitors.
Most analysts conclude that two factors are primarily responsible for this huge shift in investor attitude. The first
factor is investor experience with mutual funds over the past 30 years and the realization that only very few actively
managed funds can outperform the market over the medium to long term. The second factor are the numerous
inherent structural advantages that ETFs have compared to mutual funds.
From a business perspective, one major drawback with passive investment products is that they cannot be patented
and are very easily replicated. Passive fund managers are continuously refining their investment products, since they
rely heavily on both low management fees and fund costs, as well as low tracking errors, to attract new investor
funds.

ALTERNATIVE INVESTMENTS
Alternative investments generally refer to non-traditional funds, such as hedge funds, private equity, venture
capital, real estate, infrastructure funds, LPs and leveraged buyout (LBO) funds. While based on standard
investment management skills, these types of investment mandates usually require other investment management
skills and administrative processes that are not part of traditional long-only investment strategies, which invest
in publicly traded stocks, bonds and money market instruments. Alternative investments are discussed further in
Chapter 11.
Depending on the particular alternative investment strategy, the following additional investment management
skills and processes are required:
• Short sales of publicly traded securities
• Security borrowing and financing
• Leveraging and the use of derivatives
• Negotiating private placement investments
• Pricing and valuing non-marketable securities

To be effective, the entire institutional investment management firm must be properly resourced to be able to
manage alternative investment mandates. Appropriate staff and systems must be in place prior to managing these
types of mandates. Compared to a firm that invests long-only, quite a number of major operational changes would
need to be made.
First, legal and accounting services must be available in order to assist portfolio managers in assessing and
negotiating private placements. No two private placements have the same offering memorandum and associated
documentation, and it is a portfolio manager’s responsibility to ensure that an investment’s terms and conditions

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are clearly understood and valued correctly. Often, these agreements are sufficiently sophisticated that managers
use legal and accounting counsel to prepare and interpret them.
Second, executing and accounting for short sales of public securities is somewhat different from only buying
securities (long) and then selling them later for cash. Short sales of securities also require adherence to securities
laws and stock exchange rules that, of course, do not apply when purchasing the same securities.
Third, administration staff must be properly trained in all aspects of securities borrowing and financing. Margin
calculations are performed daily and margin calls are a common occurrence. Short sales involve many market
conventions and practices that are not part of long-only investing, and administrative staff must be very familiar
with them.
Fourth, the valuation of non-marketable or publicly traded securities must be performed in an extremely rigorous
and documented process. Portfolio management theory suggests that investments in illiquid and non-marketable
securities can add benefits to an overall portfolio. However, investing in these types of securities brings along
the risk associated with pricing or valuing these investments. A number of firms in the alternative investment
marketplace have encountered serious problems by not being able to properly value their investments in these
types of securities. An institutional investment management firm that manages these types of investments must be
extremely diligent in ensuring that robust models or procedures are in place to obtain realistic pricing for their non-
marketable securities.

GLOBAL MANDATES
It is a major step for a domestically focused Canadian institutional investment management firm to decide to invest
globally, and it potentially involves a significant number of changes to the firm’s structure and operations.
Normally, only larger institutional investment management firms undertake global investing. This is the case
because of the sizable investment in resources a firm needs to make to be able to properly invest outside of their
domestic capital markets. Due to time zone differences and the relatively few internationally experienced portfolio
management personnel in the domestic market, many domestic firms decide to establish a physical presence in the
geographic areas of the global markets in which they intend to invest.

EXAMPLE
A Canadian-based institutional investment management firm with its head office and investment management
team located in Canada would likely decide to establish a permanent portfolio management team in London or
Paris when investing in European markets, and a similar operation in Tokyo when investing in Far East markets.

When a firm decides to expand into global mandates, it essentially needs to be rebuilt in each and every market it
plans to invest in. Operations and reporting structures become larger and definitely more complicated. The firm
must ensure that all of the best practices and procedures it employs in its domestic markets are transposed into
its foreign operations. It is extremely important that all of these practices and procedures also incorporate the
regulations and institutional investment management practices in those foreign markets.

OFFSHORE INVESTMENTS
Some institutional investment management firms offer investment funds and products that are registered (or
unregistered) in jurisdictions outside of Canada. These products tend to be offered and managed by firms involved in
the areas of LPs and hedge funds.
There are two primary areas of structure and operations that an institutional investment management firm must
modify when offering offshore-based investment funds.
First, additional legal and tax counsel support is required to prepare the fund or investment product’s offering
documents, as well as to register the investment fund or structure in the offshore jurisdiction. Some of the larger

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legal and accounting firms with capabilities in both the domestic market and the contemplated offshore locations
are involved when creating and registering these types of investment funds. Alternatively, some institutional
investment management firms will hire appropriate counsel in the domestic market and then hire different counsel
in the foreign jurisdiction. In addition, offshore-based funds can involve substantial tax risk and any firm that offers
them must address this risk appropriately.
Second, from an operational point of view, a domestic firm must make appropriate arrangements to ensure that
proper custody, safekeeping, security settlement and fund unitholder services are arranged for the offshore fund.
Domestic institutional investment management firms that offer offshore investment products normally acquire
these services from a suitable firm located in the offshore jurisdiction. In those particular offshore jurisdictions
where foreign investment via offshore investment vehicles are popular, a number of banks and related financial
institutions resident in the offshore jurisdiction have created turnkey service packages that deliver all of the
appropriate administrative services normally required by offshore funds.
Canadian-based institutional investment management firms that offer these types of offshore funds must, of
course, also make changes to their Canadian operations to ensure that all of the services the third-party offshore
affiliate provides are performed appropriately.

ROLES AND RESPONSIBILITIES OF INSTITUTIONAL INVESTMENT

MANAGERS
The registrations for a portfolio manager-advising representative and a portfolio manager-associate advising
representative are granted to the individuals employed by an EMD who are responsible for managing investors’
funds and operating the EMD. As noted earlier, individuals who apply for a portfolio manager-advising
representative or portfolio manager-associate advising representative licence must meet certain education and
investment experience qualifications. An individual with a portfolio manager-advising representative or portfolio
manager-associate advising representative licence is usually able to retain and transfer this licence when changing
employment from one EMD to another.
Meanwhile, the EMD is the corporate entity that employs the portfolio manager-advising representatives and
portfolio manager-associate advising representatives, and offers the skills and capabilities of its staff to appropriate
investors. The EMD is the legal entity that offers the investment products and related services.

ADVISORY VERSUS SUB-ADVISORY RELATIONSHIP

By regulation, all investment funds must be managed by one — and only one — investment manager, who is
required to be registered as a portfolio manager. This particular investment manager is ultimately responsible for
the management of the fund and all of its assets. All of the fund’s offering documents must include the name of the
investment advisor who is managing the fund.
However, sometimes the firm managing an investment fund will make use of additional investment advisors when
it believes their expertise would be appropriate and beneficial. These advisors contract with and report to the fund’s
named investment advisor, and are referred to as sub-advisors. The fund’s named investment advisor assumes
responsibility for all of the sub-advisors’ actions. In addition, any failure of a sub-advisor to operate at the same
standard as the fund’s investment advisor is viewed by the regulators as the failure of the fund’s investment advisor
to fulfill their roles and responsibilities to the fund.
Accordingly, the fund’s investment advisor must undertake a detailed due diligence review of all potential sub-
advisors before entering into a sub-advisory investment management agreement. A sub-advisor, although usually
only responsible for a portion of the fund’s assets, must conduct their portfolio management and business affairs at
the same level of standard as the fund’s investment advisor.

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Figure 4.8 depicts the standard relationship between an investor, an investment product or fund, an investment
advisor to the fund and any sub-advisors hired by the investment advisor.

Figure 4.8 | Advisory Versus Sub-Advisory Relationship

Mutual Fund (2) Pooled Fund (3)

Fund Fund

Fund Manager EMD

Advisor (Portfolio Manager) (1) Advisor (Portfolio Manager) (1)

Sub-advisor Sub-advisor Sub-advisor Sub-advisor Sub-advisor Sub-advisor

Notes: 1. Each fund has only one advisor, but can have any number of sub-advisors.
2. Mutual fund: The fund is usually a trust, but a corporation may also be used.
3. Pooled fund: The fund is usually an LP if the EMD is offering the fund. The fund is often a trust and is a segregated account.

MANAGEMENT STRUCTURE OF CANADIAN MUTUAL FUNDS

The creation, management and distribution of investment funds in Canada involve a number of different parties.
Each of these parties brings unique skills and processes that, when carefully selected and properly combined, can
contribute to a well-structured and functioning investment fund.
For instance, it is useful to consider the various relationships involved in managing and distributing a Canadian
mutual fund. A mutual fund structure is a good example, since it involves all of the services that could be required
by virtually any other type of investment fund vehicle offered in Canada. Figure 4.9 depicts the relationships
between the various parties involved in the management of a Canadian mutual fund.

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Figure 4.9 | Management Structure of Canadian Mutual Funds

Investor

Trustee Mutual Fund Trust Principal Distributor

Portfolio Advisor Fund Manager Custodian

Independent Review
Registrar Auditor
Committee

The primary roles and responsibilities of each separate entity depicted in Figure 4.9 are discussed below.

FUND MANAGER
The fund manager is a mutual fund’s creator and sponsor. Its primary role and responsibility is to provide, or
arrange to provide, for the day-to-day administration of all aspects of a mutual fund’s operations. As with all parties
included in a mutual fund’s management, the fund manager is a corporate entity.
The mutual fund manager is normally the holding company or is nearest to the highest-level company in
the corporate structure, which is certainly the case with mutual funds that are managed by major banks and
independent mutual fund companies in Canada. This has the additional benefit of helping to build the manager’s
brand name and its association with the success of the mutual fund venture.
The fund manager’s primary responsibilities are as follows:
• Preparing and filing the mutual fund prospectus and all related regulatory and legal documents.
• Ensuring that all of its service providers exercise due diligence in creating, managing and distributing the mutual
fund.
• Negotiating appropriate service contracts with all of the mutual fund’s service providers.
• Ensuring that all service providers conduct their activities and affairs according to regulatory, legal and mutual
fund industry best practices.

PRINCIPAL DISTRIBUTOR
The principal distributor is responsible for a mutual fund’s marketing and distribution. It is usually a wholly
owned subsidiary of the entity registered as the mutual fund’s manager. In the case of mutual funds, the principal
distributor must be registered as a mutual fund dealer.
The principal distributor’s primary responsibilities are as follows:
• Preparing all marketing and distribution materials related to the distribution of mutual funds. As a key part
of this particular responsibility, it must ensure that all marketing and sales activities are conducted in strict
accordance with both regulatory requirements and mutual fund industry best practices. It must also ensure that
all third-party firms and their staff who are involved in distributing the mutual funds are properly registered to
sell and distribute mutual funds.

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• Negotiating and securing appropriate sales and distribution contracts between the mutual fund manager and
the various third-party distributors it plans to use.

TRUSTEE
A mutual fund’s assets are normally held in a trust. The trustee holds the title to the property (the cash and
securities) of a mutual fund (trust) on behalf of its unitholders. The trustee operates under the terms described in
the mutual fund’s declaration of trust. In the case of a large Canadian bank that offers mutual funds, the trustee is
often a wholly owned subsidiary of the bank that specializes in offering trust services. Alternatively, in the case of an
independent mutual fund company, the trustee is usually a third party, such as a trust company, that specializes in
offering these services to mutual funds.
The trustee’s primary roles and responsibilities are as follows:
• It is the legal owner of the trust assets and must maintain clear and continuous title/ownership of the mutual
fund’s assets.
• It must operate under the terms of the mutual fund’s declaration of trust, and exercise that authority for the
sole interest of beneficiaries, who in this case are the mutual fund’s unitholders.

CUSTODIAN
The custodian of a mutual fund holds all of the fund’s cash and securities, and ensures that those particular assets
are kept separate from any other cash and securities that it might be holding. Generally speaking, the custodian
functions as the safe keeper for the mutual fund’s assets.
The custodian’s primary roles and responsibilities are as follows:
• To maintain complete and continuous physical control over all of the mutual fund’s assets (safekeeping role).
• To provide for the proper settlement of all of the fund’s security transactions (security settlement role).

REGISTRAR
The registrar of a mutual fund keeps a current register of the individual owners of each unit of the fund. They receive
information on a daily basis from the principal distributor, including the investor’s name and other particulars, along
with the number of the fund’s units that this particular investor has purchased or sold, as well as their holdings at
the close of each business day.

AUDITOR
The auditor of a mutual fund audits the fund’s annual financial statements and provides an opinion as to whether
they are fairly presented in accordance with accounting standards.

INDEPENDENT REVIEW COMMITTEE

All Canadian mutual funds require an independent review committee, which reviews conflict of interest matters
referred to it by the fund manager and provides a recommendation, or, where required, an approval to the manager
relating to such matters. The members of the independent review committee are appointed by the fund manager.
None of the committee’s members can be an employee, director or officer of the manager; or an associate or
affiliate of the manager; or, to the knowledge of the manager, an associate or affiliate of a portfolio sub-advisor.
Independent review committees are created in accordance with NI 81-107; Independent Review Committee for
Investment Funds.
In the normal course of business, the independent review committee reports to the fund manager. The committee
works closely with the fund manager and receives routine reports and information from the manager that allow
them to perform their duties.

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The independent review committee’s primary purpose is to ensure that conflict of interest situations that may
develop when managing the mutual fund are addressed in an appropriate manner.

PORTFOLIO ADVISOR
The portfolio advisor provides, or arranges to provide, investment advice and portfolio management services to a
mutual fund. They are an institutional investment manager with the required regulatory licences.
The portfolio advisor performs a number of duties as outlined in their investment management agreement with the
fund manager, including the following:
• Assisting the fund manager in developing appropriate investment objectives and guidelines for each mutual
fund mandate.
• Providing for the effective daily portfolio management of each mutual fund in accordance with the investment
guidelines and restrictions for each mutual fund mandate.
• Providing the fund manager with timely reports on investment strategy and periodic returns for each mutual
fund.
• Supporting the fund’s distribution and client service by attending and presenting at various meetings with the
fund’s distributors and registered staff.

PORTFOLIO MANAGER’S ROLES AND RESPONSIBILITIES AS

A GENERAL PARTNER
As discussed earlier, an LP is often used as a fund structure. In this particular arrangement, the institutional
investment manager serves as the general partner to the LP. In this structure, each individual investor is a separate
limited partner.
As a general partner, the institutional investment manager has a fiduciary duty to the limited partners and must
always act in their best interests. The general partner not only provides direct investment advisory services to
the LP’s portfolio, but must also provide, or arrange to provide, all other services required to support the proper
functioning of an LP, including third-party services, such as custody/safekeeping, auditing, legal assistance and
partnership accounting.

INVESTMENT MANAGEMENT FEES

Investors may pay a number of different fees and expenses associated with the management of their investment
assets.
The type of fees and expenses investors pay depends on the type of investment product. In the case of Canadian
mutual funds, the following is a list of the typical fees and expenses that unitholders pay on an annual basis:
• Fund manager fees (often include sales and distribution-related expenses, such as trailer fees)
• Fund administrator (registrar) fees
• Fund custody and safekeeping fees
• Fund legal and audit expenses
• Commissions and fees related to security transactions
• Investment management fees

As discussed earlier, and as evidenced by the length of the list above, a number of different services are required in
order to properly create, offer and manage an investment product or fund. Interestingly, most mutual fund investors

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assume that the majority of the total fees they pay are for the services of the institutional investment manager who
is managing the fund. This assumption is certainly not accurate in most situations.

EXAMPLE
For a typical Canadian large-capitalization equity mutual fund, unitholders might pay somewhere in the range of
2% to 2.5% per year in fees. In this case, the investment management fee paid directly to the fund’s sponsor and
a manager (or portfolio manager) would typically be in the range of 40 basis points to 75 basis points. As such,
the institutional investment manager’s fee is only about 20% to 30% of the total fees and expenses charged to
the mutual fund’s unitholders.

Most of the fees charged to a mutual fund’s unitholders are paid to other third-party service providers and to the
fund’s distributors as trailer fees or commissions.
Although the fees paid to a fund’s institutional investment manager appear low, they can lead to substantial
profitability for the manager as the amount of assets under management grows, because of the fixed cost aspect
of institutional investment management. The costs and expenses of operating the institutional investment
management firm generally grow only marginally with the growth of assets under management, especially if they
are consolidated into a limited number of funds or portfolios managed by the institutional investment manager.
Investment management fees vary by the type of mandate for the fund, with money market mandates being
the lowest, followed by fixed income or bond mandates, then by large equity mandates (with the second most
expensive fees) and, finally, by small-capitalization or sector-specific equity mandates, which have the highest
investment management fees of all.
Table 4.2 provides a range of typical investment management fees charged for four standard mandates that are
invested in the Canadian financial markets.

Table 4.2 | Typical Investment Management Fees

Mandate Typical Range of Investment Management Fees

(Domestic Markets) (bps/year)
Money market 20 to 30
Fixed income 35 to 50
Equity — large capitalization 40 to 75
Equity — small capitalization and specialty 65 to 100+

As mentioned earlier, global investment mandates are becoming more popular with investors and are experiencing
growth, primarily in equity markets, with a smaller allocation going to global fixed income markets. Global
balanced fund mandates are also becoming more popular. Global investment mandates typically have much higher
investment management fees compared to the comparable asset class in the domestic Canadian market. As an
example, a large-capitalization global equity fund would typically have investment management fees starting in the
range of 100 basis points per year and often extending as high as 175 to 225 basis points per year.
As the institutional investment marketplace has become more competitive, it is common for institutional
investment managers to negotiate a tiered investment management fee (in basis points) that declines as the size
of a fund increases. This is an acknowledgment by institutional investment managers that, as a fund grows, they
should share with investors or fund managers some of the economies of scale that are associated with direct
investment management activities.
A fund manager charges a mutual fund’s unitholders for all of the fees and expenses associated with the fund’s
operations, and then, in turn, disburses the fees to the fund’s various service providers, including the institutional

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investment manager. When an institutional investment management firm is offering its services via a pooled
fund or limited product structure, it acts in a similar capacity as the manager of a mutual fund. The institutional
investment manager charges the pooled fund’s unitholders or limited partners — or both — the various fees and
expenses associated with the operation of the pooled fund or LP, in addition to its investment management fee.

PERFORMANCE-RELATED FEES
Up until the late 1990s, virtually all investment management fees were charged on the basis of the value of
the assets under management at current market prices. An institutional investment manager would increase
its investment management fees by increasing the investment portfolio’s value. This objective was attained by
accommodating strong capital market returns, resulting in higher prices for the securities, and also by successful
marketing efforts that brought more investors and their assets into a fund.
These types of asset-based fees comprise the vast majority of investment management fee agreements for mutual
funds, and also for most pooled funds and LPs. Asset-based investment management fees are the norm for long-
only investment mandates, and where a fund’s performance is usually compared to an appropriate peer survey or
market index return.
However, in general, asset-based fees are not the only fees charged in hedge fund or alternative investment
strategies. In these cases, an investment manager’s performance is measured on an absolute basis, versus the
relative basis that is commonly used in those investment strategies that can only invest long-only and are unable to
employ short sales or leveraging.
Hedge funds normally charge two types of investment management fees, as follows:

Asset-based fees This fee is called an investment management fee in the hedge fund industry. Hedge
fund management fees are in the range of 1.5% to 2% of assets under management.
However, for a hedge fund investment manager, the real attraction is the performance
fee it charges.

Performance fees A fixed percentage of the increase in a portfolio’s value over a certain period of time.
Hedge fund performance fees are typically set at 20% of the increase in a fund’s
value. Hedge funds marketers are quick to point out to potential investors that the
performance fee they charge is appropriate and beneficial, since it more closely aligns
the interests of the institutional investment manager with those of the hedge fund
investor. Hedge fund investors appear comfortable with this type of compensation
arrangement.

During the last few years, there has been some blurring of the compensation for long-only investment mandates,
versus those mandates that apply to hedge funds and other alternative strategies. Canadian mutual fund
regulations permit funds to engage in a limited amount of short selling within mutual fund portfolios. The short
sale restrictions for mutual funds are much more limited than the standard hedge fund’s ability to make short sales.
Short sales are not allowed to be more than 20% of a mutual fund’s net asset value.

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Exhibit 4.3 | The Keys to Success: Business Management and Portfolio Management Skills

When looking at them from the outside, and from a customer’s perspective, many types of businesses appear very
simple or straightforward. The same opinion or conclusion undoubtedly applies to the institutional investment
management industry. Many beginners to the industry also share this naive understanding, only to have their
eyes opened very quickly after a couple of days on the job with a new institutional investment management firm.
Although extremely important — and difficult to achieve over time — earning competitive rates of return on
portfolios is only one aspect of the numerous skills and abilities required in order to create, manage and grow a
successful institutional investment management firm.
Indeed, a lack of good business management skills is often the reason for the mediocre growth of institutional
investment management firms, and perhaps even their eventual failure. It is important to have a clear understanding
of all of the administrative and general business issues and decisions that are part of starting and operating a new
institutional investment management firm. At some point in the future, the failure to plan and implement effective
administrative procedures can and surely will come back to haunt the firm and its owners.
Some of the negative effects of operating an institutional investment management firm at below standard
administrative procedures are as follows:
1. An institutional investment management firm could fail an audit examination by the firm’s securities
regulator(s). Audit review letters from securities regulators articulate operational and other deficiencies
identified during the regulator’s routine on-site review of an institutional investment management firm.
2. A number of large institutional investors often conduct their own operational due diligence examinations
of the institutional investment managers they contemplate hiring. If they find something lacking in a firm’s
operational procedures, they may not hire the firm.
3. Problems arising from poorly designed or executed administrative processes often distract an investment
management firm’s senior management and portfolio managers, causing them to focus on those problems
rather than on portfolio performance or asset growth.
4. A history of operational or administrative weaknesses can escalate the premiums for a firm’s required business
insurance because of its higher risk profile assessment.
5. Finally, should the failure of administrative procedures result in a financial loss for any of an institutional
investment management firm’s investors, the firm could face civil litigation from its investors to recover
the loss caused by its substandard administrative procedures and business practices. There are two costs
associated with this particular situation: the potential damage payment resulting from an investor’s successful
litigation, and the potential loss of future institutional investors who decide not to consider the firm’s services
based on its litigation history.

INDUSTRY CHALLENGES
Portfolio managers should understand all of the major challenges facing the institutional investment management
industry today. This understanding will help them properly develop and execute business strategies to optimize their
firm’s results over time.
Chapter 3 discussed a number of the primary factors that contributed to the profound growth of the financial
services industry in general, and the investment management services sector in particular, over the past several
decades. Many of these factors, such as demographics (the Baby Boom generation); buoyant economic growth,
particularly in the developed world; and continuing technological advances that support the growth of an
information-intensive industry like investment management, are all still in place and will likely continue to promote
growth in this industry.

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However, although the total size of the investment pie continues to grow, the institutional investment management
industry faces a number of industry-wide challenges. Some of these challenges are not new and are likely to
linger. Other challenges are new to the scene and appear poised to become even more important in the future.
The purpose of this section is to discuss what these challenges are and how they affect institutional investment
management firms, as well as how various firms deal with them.

INVESTMENT PERFORMANCE
When asked what their number one challenge is, virtually every institutional investment management firm would
quickly say investment performance. For institutional investment managers, the key success factor remains their
ability to earn competitive rates of return for their investors over time. Institutional investment managers are hired
with the implicit expectation that they will be able to grow their investors’ wealth faster than competing investment
managers.
Usually, institutional investment managers place heavy emphasis on explaining their historic returns and the
advantages or uniqueness of their investment strategy in all marketing literature and during all presentations to
potential investors. The reality is that investment success over medium- and long-term horizons accrues to only a
very limited number of managers. Unfortunately, although a number of investment strategies may perform well
over short time horizons, very few of these same strategies provide competitive rates of return over longer time
periods.
Interestingly, the actual rate of return, which is most important to a client, is generally not the most important
performance number to an institutional investment manager. Institutional investment managers are very concerned
about their performance in relation to the appropriate market indexes and their peers’ performance. As indicated
in Chapter 3, a number of services exist that provide information about fund managers’ performances, ranking
them on the basis of relative performance, in order to aid both individual and institutional investors in assessing
institutional investment managers.

ACCESS TO SUITABLE DISTRIBUTION

As with most business enterprises, a limited number of factors primarily influence the degree of success a firm will
ultimately realize. To be financially successful, an institutional investment management firm must not only have
a sound investment strategy that delivers competitive rates of return over time, but it must also have assets to
manage. The ability to generate competitive rates of return alone will be of benefit to an institutional investment
management firm only to the extent that it has a sufficient amount of assets under management from which to
earn investment management fees, thereby sustaining itself and generating the capital needed to grow.
Many institutional investment management firms have strength and resources in the area of direct portfolio
management capabilities, but they might not have built their distribution capabilities. From time to time,
institutional investment management firms must decide whether they want to commit resources to grow their
distribution capabilities internally or acquire these capabilities by entering into business relationships with firms that
do have the desired strengths and capabilities. Institutional investment management firms deal with this issue in
three basic ways.

INVESTING IN RESOURCES
First, some firms have decided to invest in the resources to build an internal distribution team that can optimize
growth in their assets under management. This is the direction that a number of larger privately owned institutional
investment management firms in Canada have taken. These firms are closely held by the active managers of the
firm, and they prefer to have an internal distribution capability rather than enter into distribution agreements with
third-party firms.

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EXPANDING THE DISTRIBUTION NETWORK

Second, some institutional investment management firms have actively sought to expand their distribution
networks by entering into agreements with suitable third-party firms. This arrangement benefits institutional
investment managers by reducing the capital and resources needed to build a distribution resource similar to the
capabilities of their third-party partners. Another advantage is that the distribution capability becomes instantly
available upon executing the agreements, whereas it would take an extended period of time for a firm to build an
internal resource of similar capabilities.
These agreements also work to the benefit of third-party firms with the distribution capabilities, since they gain
access to a particular investment management strategy or product that might not be otherwise available in the
marketplace. Assuming an institutional investment manager’s products suit a third-party distributor’s clientele, they
now have the opportunity to realize additional sales and distribution fees and commissions. The major drawback to
this type of business arrangement is that neither party has effective control over the missing resource, whether it is
investment management skills or distribution capabilities.

PURSUING BOTH OPTIONS

Third, some institutional investment management firms decide to effectively pursue both options — expand their
internal distribution capabilities and enter into third-party distribution agreements with appropriate firms. In this
case, care is taken to ensure that the distribution resources — the internal and third-party ones — do not compete
head-to-head for the same potential clients.

EXAMPLE
This can apply to internal distribution staff that focus solely on distributing a firm’s products to institutional
investors, while a third-party distribution firm focuses solely on distributing products to high-net-worth investors,
or in the case of mutual funds, even individual retail investors.

INCREASED COMPLIANCE REQUIREMENTS

Over the past two decades, all sectors of the financial services industry, including investment management, have
committed additional resources to increasing the size and sophistication of their respective compliance-related
capabilities. Some of these improvements are the result of management decisions to operate their companies at
best practices standards, while others are the result of changes in regulatory requirements and IIROC standards.
These changes generally emanated from stock market volatility or well-publicized failures and shortcomings of
some financial services companies.
Compliance has been strengthened throughout these companies in various forms, including the following:
• More rigorous Know Your Client (KYC) processes and increased sales/marketing oversight
• Implementation of new IT software solutions that provide real-time monitoring of adherence to investment
guidelines
• Restrictions for managed client portfolios and investment funds

In aggregate, these new and additional compliance-related activities and processes generally lead to some
combination of the following three main benefits:
• Fewer issues arising from routine regulatory and self-regulatory organization compliance and supervisory audits
• Operating efficiency improvements arising from smoother business operations and fewer negative surprises for
senior management
• Increased level of client satisfaction and decreased risk of client complaints and litigation

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These compliance improvements can be extremely costly to implement, both in terms of upfront software costs
and higher post-implementation staffing expenses.
These compliance improvements undoubtedly lay the foundation for a better and stronger Canadian investment
management industry. Unfortunately, they come at a time when competitive pressures from direct competitors, as
well as new products, such as ETFs, are putting downward pressure on industry revenues.

INCREASING COMPETITION
Many competitors are entering the institutional investment management business because of the appeal of its
inherent economies of scale and relatively low capital requirements. It is a prime example of an industry which
is, qualifications aside, relatively easy to enter. Many institutional investment management firms can generate
extremely high levels of profitability, particularly if their investment results have been attractive and they have
realized good growth in their assets under management.
As discussed earlier, another contributing factor to increased competition is the profound growth in the number of
institutional investment management firms that offer a full range of services supporting the industry. These third-
party services are not only competing for the same clients as established firms, but they are also contributing to the
decline in the necessary capital costs to start an institutional investment management firm, since they do not have
to invest resources at the start-up phase to perform these activities themselves.
Of course, low barriers to entry have also contributed to downward pressure on investment management fees,
because these start-up investment management firms generally have very small capital costs to recover. Like many
businesses, new entrants can attempt to gain market share and accumulate assets under management by offering
investors investment management fees that are below the competition. Some parts of the investor marketplace are
more sensitive to investment management fees than others, which provides growth opportunities, particularly for
those investment management firms that are willing to provide their services at a discount.
In response to this competitive pressure, many established firms have resisted, within limits, from reducing their
investment management fee schedules. These firms are relying on their demonstrated strengths in the areas of
long-term portfolio performance and client service as a tool or argument to maintain their existing investment
management fee structure.
This downward pressure on investment management fees is likely to continue into the foreseeable future. Some
firms will experience more downward pressure than others, depending on the type of clients they are pursuing and
the pricing actions of their major competitors.

GLOBAL COMPETITORS
As with many sectors of today’s economy, the trend toward globalization is also firmly in place in the institutional
investment management industry. The unrelenting drive to accumulate more and more assets within the
global institutional investment management industry has led many firms to expand both their portfolio
management operations and their distribution activities beyond their home country. Significant improvements
in communications and technology, as well as the ongoing liberalization of capital markets, have provided a
tremendous boost to the growth of global competition in the investment management industry. Another major
factor causing the growth of global competition emanates from investors themselves. Many investors, both
individual and institutional, want to increase their amount of portfolio diversification and therefore have started to
invest a larger portion of their portfolio outside of their domestic capital markets.
Global competition is a threat on two basic levels. First, a domestically focused institutional investment manager
will see the potential growth rate for assets under management diminished as an increasing proportion of its
investors’ assets are managed by foreign-based global competitors. Second, by their global investment mandate,
foreign global competitors are required to invest a portion of their investors’ assets in the Canadian financial
markets. These firms contribute to the premium placed on high-performing portfolio managers, since the global

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competitors occasionally decide to hire competent institutional investment managers to assist them in their
Canadian operations, making it harder for all firms to attract and retain key employees (as discussed in the following
section). Some foreign global institutional investment managers have hired Canadian domestically focused
institutional investment managers on a sub-advisory basis in order to manage the Canadian portion of their global
mandate. Many of these relationships are not long-tenured and it is not clear whether more foreign institutional
money managers will take this route or go the direct route of hiring staff from domestically focused Canadian
institutional investment management firms.

HUMAN RESOURCES
The institutional investment management industry is not a bricks-and-mortar-type of undertaking. As noted above,
fixed capital requirements are very low. Staff skills and ability drive this industry.
The two primary skills that are coveted by the industry are the ability to generate competitive rates of return on
portfolios and the ability to market and accumulate assets from investors for a firm to manage. These skills are
very transportable from one investment management firm to another, and an employee’s success in either or both
of these two areas is very easy to quantify and readily communicated throughout the institutional investment
management community. Through marketing literature, trade journals and even the business press, it is very easy to
determine the success of the various institutional investment management firms. It is also easy to determine which
individuals in a particular firm are primarily responsible for a firm’s growth and success. This makes the human
resources aspect of institutional investment management very dynamic and competitive in nature.
Furthermore, investment management firms, even those with strong brand name recognition, can attribute a
significant portion of their success to the abilities of a handful of individuals who have demonstrated particularly
good investment management or marketing skills. Some firms have deliberately adopted the “star manager”
approach when marketing their firm to investors. Although this can often boost the firm’s growth rate in assets
under management in the short term, it also creates a risk for the firm if these individuals decide to leave the firm.
Compensation schemes also vary throughout the institutional investment management industry and can be a
decisive factor in obtaining and retaining key employees. The ability to offer equity in a firm is primarily available
to independent and privately owned institutional investment management firms, making it possible for them to
attract high-performing portfolio managers away from larger firms, such as banks, life insurance companies and
pension plans, which are unable to offer equity ownership. Since the loss of a key portfolio manager can be just as
detrimental to large firms as to smaller ones, it is important to structure attractive and competitive compensation
programs to not only attract but also retain productive portfolio management staff.

GROWTH OF PASSIVE INVESTMENT MANDATES

Passive investing was a very small portion of the institutional investment management market up until the mid-
1990s. However, since then, an ever-increasing proportion of investors, both individual and institutional, have
decided that, after incorporating fees, active investment management does not result in returns superior to those
generated by a passive investment style.
This shift away from active investment management strategies toward passive investment management strategies
is a threat to the industry for two primary reasons. First, it potentially diverts assets from the institutional
investment management firms that manage solely on an active basis. This diversion potentially impacts the entire
institutional investment management industry, because very few institutional investment management firms offer
both passive and active investment management products. Second, the investment management fees associated
with passive investment mandates are usually substantially lower than those associated with active investment
management strategies.
In addition, in the past few years, we have witnessed significant growth in passive products in the form of exchange-
traded index or index-like products — that is, ETFs. These types of funds are accumulating investor assets that

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might otherwise be invested in a fund that uses an active investment strategy. These types of products were created
specifically to appeal to those investors who favour passive investment strategies and simply want exposure to
particular equity markets or sectors of the equity markets.
Passive investments continue to grow both in assets under management and as a proportion of total investor
assets. The challenge for institutional investment management firms is not only to earn rates of return that are
competitive with the best results of other active institutional managers, but also to be competitive with the rates
of return realized by passive investment strategies, since the average active portfolio underperforms its passive
portfolio benchmark.

CORPORATE GOVERNANCE

ASPECTS OF GOOD CORPORATE GOVERNANCE

Despite the fact that virtually all institutional investment management firms are privately owned, it is still critical
that they operate with good corporate governance practices. In fact, a number of high-profile institutional
investment management firms are renowned for aggressive tactics against the management of publicly traded
companies in which they hold shares — if they feel these companies are not operating with sound corporate
governance practices.
As applied to an institutional investment management firm, good corporate governance practice involves a number
of aspects, including the following:
1. The firm’s owners and management must instill an attitude that supports the execution of their fiduciary duty
and compliance with all appropriate regulations and laws pertaining to all aspects of their operations.
2. The firm must create policies and procedures that can be monitored on a real-time basis to ensure that all
aspects of their operations remain in compliance. In order to do so, the firm must invest in systems and
personnel to monitor its activities relative to its policies and procedures.
3. The firm must create and implement an appropriate organizational design in order to ensure that the corporate
reporting structure facilitates the independence of areas such as compliance, audit and legal versus its
investment management and marketing functions.
4. The firm must be diligent and stay abreast of all good corporate governance developments. These changes and
their applicability to the firm should be assessed and decided upon promptly.

POTENTIAL BENEFITS OF GOOD CORPORATE GOVERNANCE

For institutional investment management firms, there are many potential benefits of having good corporate
governance practices, as follows:
1. As part of their due diligence hiring process, institutional investors are more often asking specific questions
regarding a firm’s corporate governance practices. With the newsworthy failure of some firms, institutional
investors have become extremely focused on clearly understanding the corporate governance practices of
potential firms. They are looking for an appropriate organizational structure and policies and procedures that
ensure a firm’s proper functioning.
2. Good corporate governance should decrease the risk of a firm’s business failure by promoting its proper
functioning and avoiding potential situations that could adversely impact the firm. A strong compliance
structure and reporting mechanism can certainly reduce the risk of loss from both honest errors and actions by
employees with dishonourable intentions.

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 CHAPTER 4 | THE INVESTMENT MANAGEMENT FIRM 4 • 35

3. Good corporate governance is quickly becoming a major point of consideration for senior staff and portfolio
managers when contemplating a change of employment to another firm. These individuals are keenly aware of
the serious issues that can occur in firms that operate in a manner that does not fully embrace good corporate
governance principles and industry best practices.
4. Good corporate governance should also enable a firm to operate in a more organized manner. If the
appropriate governance and operational policies and practices are in place, there is an increased chance that
all aspects of a firm will run effectively and efficiently. Of course, efficient operations should lead to higher
profitability for a firm.

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4 • 36 PORTFOLIO MANAGEMENT TECHNIQUES

SUMMARY
After completing this chapter, you should be able to:
1. Describe an investment management firm’s basic ownership and explain the differences between public and
privately owned firms.
All investment management firms in Canada are structured legally as corporations to be considered for, and
receive registration from, the appropriate securities regulator or regulators.
Private ownership generally takes one of two major forms: either 100% employee-owned or employee
majority–owned with a passive external owner.
In the publicly owned structure, the investment management firm is usually organized as a wholly owned
subsidiary of a holding company that is publicly owned.

2. Describe an institutional investment management firm’s basic organizational structure.

Typically, institutional investment management firms organize their corporate departments in three
organizational groups: the front, middle and back offices. In addition, as required by securities regulators,
there must be an ultimate designated person (UDP) and chief compliance officer (CCO).

3. Identify and explain the major types of investors.

The major types of investors are non-exempt and exempt investors.
Non-exempt investors are small individual retail investors.
Exempt investors meet certain qualifications. The exempt market is composed of both institutional and
individual investors.

4. Discuss the major investment product structures that institutional investment management firms manage.
Institutional investment managers in Canada offer their services by way of four main channels: pooled funds,
segregated/managed accounts, limited partnerships and sub-advisory capacity.

5. Explain how the types of investment mandates an institutional investment management firm offers can affect
its structure and operations.
An institutional investment management firm’s structure and operations are also dependent upon the
types of investment mandates it manages. The key types of investment mandates are domestic single-
sector mandates (equity, fixed income and money market) and balanced funds, specialty- or sector-focused
mandates, style-focused mandates, passive investment management, alternative investments, global
mandates and offshore investments.
Alternative investments, global mandates and offshore investments can change a firm’s structural and
operational aspects.

6. Illustrate the primary roles and responsibilities of the various parties involved in the management of a
Canadian mutual fund.
Fund manager: Primary role and responsibility is to provide, or arrange to provide, for the day-to-day
administration of all aspects of a mutual fund’s operations.
Principal distributor: Responsible for a mutual fund’s marketing and distribution.
Trustee: Holds the title to the property (the cash and securities) of a mutual fund (trust) on behalf of its
unitholders.
Custodian: Holds all of the mutual fund’s cash and securities and settles all of its security transactions.
Registrar: Keeps a current register of the individual owners of each unit of the mutual fund.

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 CHAPTER 4 | THE INVESTMENT MANAGEMENT FIRM 4 • 37

Auditor: Audits a mutual fund’s annual financial statements and provides an opinion as to whether they are
fairly presented in accordance with accounting standards.
Independent review committee: Reviews conflict of interest matters referred to it by the fund manager and
provides a recommendation, or, where required, an approval to the manager relating to such matters.
Portfolio advisor: Provides, or arranges to provide, investment advice and portfolio management services to
a mutual fund.

7. Explain how an investment manager collects fees and identify the various types of fees institutional
investment management firms charge.
Mutual fund unitholders pay investment managers an investment management fee as compensation.
Hedge funds normally charge an investment management fee and also a performance fee, which is based on
the increase in a portfolio’s value over a certain period of time.

8. Describe the key challenges the institutional investment management industry faces and what actions are
being taken to mitigate these challenges.
The institutional investment management industry faces a number of industry challenges. Some of the most
important challenges are investment performance, access to suitable distribution, increased compliance
requirements, increasing competition (including global competition), attracting and retaining valued and
productive staff, and the growth of passive investment strategies.

9. Explain the critical role of governance in an institutional investment management firm’s operations.
Good corporate governance involves instilling an attitude that supports the execution of a firm’s fiduciary
duty and regulatory compliance.

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 The Front Office 5

CONTENT AREAS

An Overview of the Front Office

The Four Areas of the Front Office

Information Flow Among Front Office Staff

Front Office Best Practices

Getting Clients

Losing Clients

LEARNING OBJECTIVES

1 | Describe the typical organizational structure of a modern institutional investment management

firm’s front office.

2 | Explain the key roles and responsibilities of portfolio management staff.

3 | Explain the benefits of good security trade execution.

4 | Describe an institutional investment management firm’s typical sales and marketing strategy.

5 | Describe the role that client service plays in both retaining and growing a firm’s assets under
management.

6 | Identify the key terms and conditions included in an institutional investment management
agreement.

7 | Explain the best practices for risk control and securities trading procedures.

8 | Identify the main reasons why institutional investment management contracts are terminated.

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5•2 PORTFOLIO MANAGEMENT TECHNIQUES

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

asset mix committee peer investment manager performance

surveys
chief investment officer
portfolio accounting information
client service
portfolio management information
head of equities
portfolio managers
head of fixed income
target asset mix
investment management agreement
traders
market depth

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 CHAPTER 5 | THE FRONT OFFICE 5•3

INTRODUCTION
This chapter introduces you to the four main areas of an institutional investment management firm’s front office
and explains how information flows among its staff. Next, front office best practices are explained. We also discuss
how institutional investment management firms acquire clients and why they may lose them.

AN OVERVIEW OF THE FRONT OFFICE

A modern institutional investment management firm’s front office has four main areas of responsibility, as follows:
1. Portfolio management
2. Trade execution
3. Sales and marketing
4. Client service

Figure 5.1 shows how these four areas of responsibility are often combined into two logical sub-groups.

Figure 5.1 | The Four Main Functions of the Front Office

Front Office

Portfolio Trade Sales and Client

Management Execution Marketing Service

Portfolio management and trade execution are very closely related, and in most small institutional investment
management firms, these activities are performed by the same individual — the portfolio manager. The sales and
marketing and client service areas are also often combined into one area of responsibility, because they require
similar skills — specifically, supporting investors’ needs pre-sale and post-sale. Again, in smaller firms, these two
areas of responsibility are generally performed by the portfolio manager.
The combination of functions that an institutional portfolio manager performs in smaller firms is similar to
the multiple hats entrepreneurs wear. All of these front office duties are critical to an institutional investment
management firm’s survival and growth. To be successful, a firm must not only deliver competitive returns with
strong portfolio management and trade execution, but it must also attract and retain investors through effective
sales and client service expertise.
As an institutional investment management firm increases in size, the four areas of responsibility of its front office
are often separated and fulfilled by as many as four separate sub-groups. The amount of staffing and resources for
these four functions varies from firm to firm according to the number and type of investors.

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5•4 PORTFOLIO MANAGEMENT TECHNIQUES

THE FOUR AREAS OF THE FRONT OFFICE

PORTFOLIO MANAGEMENT
The primary objective of portfolio management is to earn a competitive rate of return on an investor’s assets. This
return must be earned with an amount of risk that is acceptable to the investor and that they have agreed upon in
advance with the institutional investment manager. Portfolio risk is controlled through the manager’s adherence to
the unique investment guidelines and restrictions applying to the investor’s portfolio.
Figure 5.2 provides the typical organizational structure for the front office’s portfolio management function at a
medium-sized or large institutional investment management firm.

Figure 5.2 | Front Office Organizational Structure

Chief Investment
Officer

Sales and Marketing Asset

Equities Fixed Income
Client Service Mix/Economist

Sales and
Domestic Domestic
Marketing

Client
Foreign Foreign
Service

CHIEF INVESTMENT OFFICER

The chief investment officer has overall responsibility for an institutional investment management firm’s portfolio
management activities. The position normally reports directly to the firm’s president; however, in a smaller firm, the
same individual may hold both positions. The chief investment officer has two primary duties:
1. Providing general management of the firm’s investment management function and the supervision of their
direct reports, such as the head of equities and the head of fixed income. This position does not normally
have any involvement in the daily management of the firm’s various portfolios.
2. Acting as the chairperson of the firm’s asset mix committee, which is usually made up of the chief investment
officer and the heads of the various asset classes the firm manages. The primary purpose of the asset mix
committee is to establish the target asset mix, which is the desired market value weighting for the major
asset classes included in the firm’s various balanced fund portfolios.

EXAMPLE
For a balanced fund made of stocks and bonds, the typical weighting for a target asset mix is 60% equities and
40% fixed income.

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 CHAPTER 5 | THE FRONT OFFICE 5•5

The asset mix committee normally meets on a quarterly basis with the purpose of reaffirming or modifying the
current weighting of the target asset mix. Most firms only make minor changes to the asset mix. In fact, over a one-
year period, the weighting of the target asset mix does not normally change by more than 5%. Interestingly, this
activity is generally the closest a chief investment officer gets to making actual investment decisions.
Given that the asset mix decision is the primary factor in determining long-term investment performance, most
firms leave this particular investment decision to their most senior investment officers, which are the members of
the asset mix committee.

HEAD OF EQUITIES
The head of equities, who reports directly to the chief investment officer, has overall portfolio management
responsibility for all of the equities managed by a firm. In most firms, equity portfolio managers will report directly
to the head of equities. In large firms that manage global equities, there is often another layer of responsibility
added, with a parallel reporting structure, with all portfolio managers responsible for domestic equity
mandates — that is, large- and small-capitalization Canadian equities, and various sector or specialty Canadian
equity mandates — will report to a head of domestic equities. All portfolio managers responsible for foreign equities
will report to a head of foreign or global equities management.
Although they are not normally involved in daily investment decisions, the head of equities does have the following
key responsibilities:
1. Providing direct managerial supervision to the firm’s equity portfolio managers.
2. Being involved in decisions to change the sector mix or cash weighting in the firm’s various equity portfolios.
Of course, these investment decisions are made within a particular portfolio’s investment guidelines and
restrictions, and are more tactical than strategic.

HEAD OF FIXED INCOME

The head of fixed income, who also reports to the chief investment officer, has overall portfolio management
responsibility for all of a firm’s fixed income and money market securities. In small to medium-sized firms, the
various fixed income and money market portfolio managers report directly to the head of fixed income. However,
in larger firms and those that manage global fixed income mandates, there is often another layer of responsibility
added.
As is the case with equities, all portfolio managers responsible for domestic fixed income and money market
mandates report to the head of domestic fixed income, while all portfolio managers responsible for managing
foreign fixed income securities report to the head of foreign or global fixed income.
Like the head of equities, the head of fixed income is not normally involved in daily investment decisions and has
the following duties and responsibilities:
1. Providing direct managerial supervision to the firm’s fixed income portfolio managers.
2. Being involved in tactical investment decisions for the firm’s fixed income portfolios.

PORTFOLIO MANAGERS
Portfolio managers are responsible for making the day-to-day investment management decisions that affect the
portfolios for which they are responsible. This is true for portfolio managers involved in all asset classes: equities,
fixed income, real estate, mortgages and alternative investments. Portfolio managers make all of the security
selection and trading decisions for their portfolios. They make these decisions within an investment management
control structure that does not require them to obtain prior approval from their respective asset class head.

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5•6 PORTFOLIO MANAGEMENT TECHNIQUES

ASSISTANT PORTFOLIO MANAGERS AND INVESTMENT ANALYSTS

Generally, an assistant portfolio manager cannot execute any security trades, or if they are permitted to, only within
very limited parameters and with a portfolio manager’s prior approval. Investment analysts are not allowed to
execute any security trades. For more information about these two roles, see Exhibit 5.1.

MANAGEMENT OF OTHER ASSET CLASSES

Some institutional investment management firms also manage securities or asset classes beyond the traditional
equity, fixed income and money market mandates. These additional asset classes or mandates and their
organizational reporting structure are as follows:

Derivatives The head of derivatives for fixed-income, equity, foreign exchange and commodity-
based mandates generally reports to the head of fixed income.

Alternative investments The head of alternative investments normally reports directly to the chief
(Hedge funds and leveraged investment officer.
buyout funds, and other types
of limited partnerships)

Passive (“index”) funds Generally, all passive investment mandates are consolidated under one portfolio
manager who uses quantitative portfolio management tools. If a large amount of
assets is managed in passive investment strategies, the head of this group usually
reports to the chief investment officer. Otherwise, they report to the head of
equities or fixed income.

Commercial and residential This group is responsible for underwriting and managing commercial and/or
mortgages residential mortgage portfolios, which are among the larger portfolios at a bank
or life insurance company. The head of this group usually reports to the chief
investment officer.

Equity real estate This group, which only exists at a bank or life insurance company, is responsible for
originating and maintaining the equity investments in commercial and/or industrial
real estate. The head of this group normally reports to the chief investment officer.

Exhibit 5.1 | Typical Career Development of a Portfolio Manager

The career development of an institutional portfolio manager generally follows a path of ever-increasing authority
and responsibility, as shown below:

Investment analyst This position is the standard entry point into institutional portfolio management. The
incumbent typically has an undergraduate university degree. An investment analyst
is typically responsible for following and analyzing a limited number of equity market
sectors or industries (e.g., transportation, banks, mining) and selected stocks in those
sectors. They generally consolidate their analysis of the third-party equity research
received from investment dealers and supplement it with the firm’s unique method of
financial analysis. This material is then provided to the assistant portfolio manager or the
portfolio manager to whom the investment analyst reports. As a rule, this position does
not include the ability or permission to make any actual decisions regarding security
transactions. An individual typically remains in this role for a period of two to four years,
depending on their individual merit and the growth opportunities within the firm.

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 CHAPTER 5 | THE FRONT OFFICE 5•7

Exhibit 5.1 | Typical Career Development of a Portfolio Manager

Assistant portfolio The next level of authority is the assistant portfolio manager; however, this position
manager does not exist at all firms. The assistant portfolio manager reports directly to a portfolio
manager. They are usually the direct day-to-day contact for investment analyst staff
and are sometimes their immediate supervisor. As such, the assistant portfolio manager
has supervisory responsibilities and some analytical duties. Depending on the particular
firm (and the portfolio manager), the portfolio manager might delegate some portfolio
management decision-making authority to the assistant portfolio manager. When
granted, this trading authority will normally be restricted in terms of a trade’s size
(dollar amount). An individual would normally be in the assistant portfolio management
position for three to five years before being considered for a portfolio manager position.

Portfolio manager As a portfolio manager, the employee now has sole authority for a portfolio’s
management. Being promoted to this position represents a key turning point in the
career path of an institutional investment manager. When entering this job, the
incumbent will typically have had anywhere from seven to 10 years of related portfolio
management training and development. Depending on their mandate, portfolio
managers report directly to the asset class head — either the head of fixed income or
head of equities. Their direct supervisory duties will include anywhere from one to three
assistant portfolio managers and (indirectly) the staff of investment analysts. Typically,
individuals remain in a portfolio manager position for five to 10 years, or longer.

Asset class head In medium- to large-sized institutional investment management firms, the next level of
responsibility up from the role of portfolio manager is the head of an asset class: head
of equities, head of fixed income or, in some firms, head of alternative investments. The
head of an asset class typically has 15 to 20 years of portfolio management experience.
The position reports to the firm’s chief investment officer. All portfolio managers in a
particular asset class report to the head of that asset class.

Chief investment As the name implies, the chief investment officer is ultimately responsible for all of the
officer firm’s portfolio management activities. Most chief investment officers have over 20
years of portfolio management experience. The chief investment officer reports directly
to the firm’s president, unless it is a small firm, in which case the same individual may
hold both positions.

TRADE EXECUTION
The primary objective of security trade execution is to obtain the best execution — meaning, the best prices at
which securities are bought or sold. There is no question that a successful portfolio manager’s primary skill is
the ability to decide when and which particular security to buy or sell. However, it is also very important for the
portfolio manager to understand how “easy” it will be to actually execute this security transaction at prevailing
market prices.
In very small firms, individual portfolio managers typically perform all of the securities trading activities for the
portfolios for which they are responsible. However, as a firm grows and its portfolio managers become more
involved in other activities, such as marketing and client service, or investment mandates become more specialized,
such as sector, industry or small-capitalization funds, the firm must decide whether to hire and provide the
resources for a trading staff.
Traders, those individuals who execute trades, are an integral part of a firm’s portfolio management operations
and team. They are usually located in the same location or trading room that houses the portfolio managers.

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5•8 PORTFOLIO MANAGEMENT TECHNIQUES

Accessibility is very important for the trading staff to function effectively, as they are generally in constant two-way
communication with the portfolio managers.
In large portfolio management firms, there are usually two separate trading staffs — one for equities and one for
fixed income. The head of the equity trading staff normally reports directly to the head of equities, and the head
of fixed income trading reports directly to the head of fixed income. However, it is customary for the trading staff
to also have dotted-line reporting relationships with the various portfolio managers for whom they trade. In other
words, although traders do not officially report to portfolio managers, they are responsible for keeping them up to
date on their trading activity.
A trader’s primary responsibility is to execute the firm’s security trading activities in an effective and efficient
manner. The primary challenge for security trading, whether it is done by a portfolio manager or trader, is to buy
or sell the requisite amount of securities at a price that is as close as possible to the currently quoted bid or offer
prices.
It is imperative for a trader to understand market depth (the number of shares available at the bid and offer price),
market sectors and the individual stocks in which the firm invests. In order for a trader to fulfill their role, they must
be in constant contact with the traders at the various investment dealer firms with which their firm trades and deals.
This constant contact gives the trader the opportunity to understand the volume of securities that can be traded on
any given day. It also enables them to develop a good estimate of the price concession that must be paid — either
by paying a price that is higher than the offer price or selling at a price that is lower than the prevailing bid
price — in order to have the firm’s trade executed.
Normally, an experienced trader understands market depth better than a portfolio manager, who has less daily
contact with investment dealer traders. The trader’s knowledge is very important to the portfolio manager, because
the information the trader provides about the price concession may lead the manager to reconsider their intentions.
Good traders also are skilled in determining which particular investment dealer might have the greatest interest in
transacting with them. Investment dealers often have both long and short positions in their own portfolios, as well
as confidential knowledge as to which of their other institutional investment management firm clients might also
have a potential interest in being on the other side of the contemplated security trade. In theory, this knowledge
should result in the best execution or trading outcome, because the negotiated price would be better than the one
achieved by filling the entire trade at the prices quoted on the stock exchanges.

SALES AND MARKETING

Institutional investment management firms are similar to other businesses in that they must sell a product or
service in order to earn revenue and, ultimately, a profit. As such, these firms must dedicate time and resources to
sell and promote their capabilities to potential investors.
In a small firm, the portfolio managers who own and operate the firm usually perform the sales and marketing
activities. This arrangement can be effective up to the point where the firm reaches a certain size and a certain
number of investors, when one of two things may occur:
• First, the firm’s portfolio performance may start to suffer since much of the portfolio manager’s time is spent
on sales and marketing activities, cutting into the time they need to dedicate to direct portfolio management
duties. As a consequence, the firm may miss investment opportunities that their competition may capture.
• Second, the firm may conclude that it is not reaching its growth potential because it is unable to dedicate
enough time to the sales and marketing efforts required to optimize its exposure to potential investors. Portfolio
managers in small to medium-sized firms work to maintain the delicate balance between these two functions.
However, as the firm grows, it must determine whether allocating part of a portfolio manager’s time to
asset-gathering activities should be done at the expense of lower rates of return.

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Over time and with growth, most institutional investment management firms decide to resource and staff a
dedicated internal sales and marketing team, whose primary function is to effectively communicate their marketing
message to potential investors in order to accumulate assets for the firm. The sales and marketing process is
outlined in detail in the “Getting Clients” section of this chapter.
Of course, the size of the sales and marketing function will primarily depend on the number of investors a firm has.
Most firms start with one or two trained marketers and remain at that level for a number of years. Other firms will
add to the sales and marketing staff according to the growth in their number of investors.
The head of sales and marketing normally reports to a firm’s president, but there is often a dotted-line reporting
relationship with its chief investment officer. This is the case because, in order to be effective, sales and marketing
staff need to maintain a close relationship with portfolio management staff.

CLIENT SERVICE
To be successful, an institutional investment management firm must deliver more than just competitive rates of
return. It must also provide investors with ongoing client service that includes timely and relevant information
about the portfolios under management. The primary objective of client service is to provide current investors with
the appropriate amount of verbal and written communication regarding the management of their assets.
In a small firm, client service duties are normally performed by the partners, who are also the portfolio managers. As
the firm grows, particularly in its number of investors, the need for a separate client service function also increases.
Building the client service function usually starts by hiring one individual with the requisite qualifications, including
strong interpersonal and communication skills, an ability to clearly understand and explain investment strategies,
and experience in servicing institutional investors, and adding others as the firm expands.
Because client service essentially involves the same skills as those needed in sales and marketing, both functions are
often performed by the same individuals, although some of the very large institutional investment management
firms have separate staff for the two functions. In any case, the head of client service normally reports to a firm’s
chief investment officer or president (see Figure 5.2).
Institutional investment management firms need to be diligent and ensure the proper resources are available to
meet the client service requirements of their current investors. These firms consider client service important for
three primary reasons, as follows:
1. Client service demonstrates to current and potential investors a firm’s level of commitment to the delivery of
an entire institutional investment management service — one that goes beyond just portfolio performance
results.
2. If done effectively, client service can be a “defensive” mechanism that helps a firm retain investors in the event
that its portfolio performance starts to deteriorate. Good client service, particularly the provision of timely and
informative communications, helps build confidence with institutional investors. This confidence can be crucial
if a firm’s investment performance starts to slip and an investor must decide whether to give the investment
manager additional time to let its strategy develop further and perhaps improve results.
3. If done effectively, client service reduces the amount of time a portfolio manager is out of the office presenting
and meeting with current and potential investors. Ideally, it is of net benefit to the firm, as it allows the
portfolio manager to focus on direct portfolio management, thereby increasing the likelihood of better
investment results.

Client service is also often viewed as an integral part of a firm’s sales and marketing efforts, in that satisfied current
clients will often allocate additional funds to the institutional investment manager as their own assets grow.

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INFORMATION FLOW AMONG FRONT OFFICE STAFF

All of the various front office staff interact with each other and with other employees at the firm, as well as with
external contacts. This section outlines the way information flows among these staff members.

PORTFOLIO MANAGEMENT
For portfolio managers, the primary information flow within a firm is with other front office staff members.
Portfolio managers will normally be in constant contact throughout the day with their counterparts within the
firm and with trading staff. Contact with other portfolio managers is very important, since they will often hear or
analyze market opportunities that might be of benefit to some of their peers. This “pooling” of investment ideas
and market intelligence is a hallmark of a smoothly functioning portfolio management team. Portfolio managers
are also in constant contact with security trading staff, which provide them with good trade execution support and
information regarding the markets, especially about particular securities, which can be of great value to a portfolio
manager.
Portfolio managers generally have less contact with sales and marketing and client service staff; it tends to happen
during particular times of the year. They work with sales and marketing staff prior to making presentations to
potential new investors, and are involved with client service staff at quarter end, when it is time to produce portfolio
management reports for investors.

TRADE EXECUTION
As mentioned above, at an internal level, traders primarily interface with portfolio managers. When establishing
a trading program, a portfolio manager normally consults with a trader first. The portfolio manager provides
the trader with a list of the equities they plan on buying and selling, and the number of shares for each planned
transaction. Generally, the portfolio manager reviews this information with the trader, who then provides advice
regarding the price at which each of the trades will likely be executed. For some contemplated trades, the trader
might make discreet inquiries to a select number of investment dealers to get a better sense of the market’s
liquidity for particular securities.
After this discussion takes place, the trader and portfolio manager agree on the trades to be executed, and the
trader starts the trading activities with the third parties. Some trades might take an extended period of time to
complete, such as those involving stocks that have a very small capitalization, that are not widely held or that are
not easy for an investment dealer to borrow and then sell (short) to the institutional investment manager.
At institutional investment management firms, the trader’s primary external contacts are the equity sales and
trading staff at the different investment dealers with which the firm has a relationship. It is fairly common for
medium- to large-sized institutional investment managers to have ongoing relationships and daily trading activities
with as many as 20 to 30 domestic and U.S. investment dealers.

SALES AND MARKETING AND CLIENT SERVICE STAFF

Internally, a firm’s sales and marketing staff primarily interface with its portfolio management staff. Although
this communication may not take place on a daily basis, the success of a firm’s sales and marketing efforts greatly
depends on how well this relationship works. Sales and marketing staff need input from the portfolio management
staff in order to update and prepare marketing materials.
Generally, portfolio managers will accompany sales and marketing staff to presentations to potential clients.
However, in the case of a firm that tries to minimize the use of its portfolio managers in external presentations, it is
imperative that the sales and marketing staff create presentations that demonstrate a very clear understanding of
both the firm’s investment strategy and the portfolio manager’s current market views.

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CLIENT SERVICE
A firm’s client service staff primarily interface with portfolio managers and the fund accounting staff. The specific
roles and responsibilities of the investment or fund accounting staff will be discussed in the next chapter, which
discusses the function of an institutional investment management firm’s middle office.
It is critical that the client service staff work very closely with the portfolio management staff, as they are often
primarily responsible for communicating the portfolio strategy and its results to institutional investors. Most firms
strive to have senior client service staff with a level of proficiency that enables them to effectively deliver the same
message as a portfolio manager, thereby reducing the number of investor meetings the portfolio manager must
attend. Client service staff are often in daily contact with portfolio managers.
Client service staff also interface with a firm’s fund accounting staff. This relationship is important, since a
significant portion of the regular communication with investors is focused on the financial and accounting
information that the fund accounting staff prepares.
Of course, at an external level, the client service staff communicate with a firm’s current institutional investors. The
contact and review process with clients is very structured and is normally built around an institutional investor’s
internal governance timetable. A typical annual client review process is as follows:

Monthly • Portfolio accounting report (details regarding the content are provided below)
• Portfolio rate of return
• Brief written investment report from portfolio manager

Quarterly • Portfolio accounting report

• Portfolio rate of return report (including performance attribution)
• A more detailed written investment report from portfolio manager
• On-site presentation by client service staff or portfolio manager, or both. In many
instances, this presentation is required on a less frequent basis — semi-annually
or annually — depending on recent portfolio performance and the institutional
investor’s level of comfort and familiarity with the firm.

The information provided to the institutional investor in the portfolio management report falls into two basic
categories:
1. Portfolio accounting information
2. Portfolio management information

PORTFOLIO ACCOUNTING INFORMATION

Portfolio accounting information is provided on a monthly basis and typically includes the following (for more
detail, see Chapter 12):
• Detailed portfolio holdings
• A report on all security transactions
• An income report

It should be noted that institutional investors generally tend to use investment structures where their assets
remain in the custody and safekeeping of a third-party custodian, not with the investment manager. Accordingly,
the institutional investor will independently receive monthly reports from the custodian that contain similar
information about the portfolio and its activity. A best practice is for an investment manager to reconcile its
investment accounting information with the information reported by the investor’s custodian, which is also

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discussed in Chapter 12. Further, it is also a best practice for the institutional investor to ensure this reconciliation
has been completed and that any discrepancies between the two reports have been addressed.

PORTFOLIO MANAGEMENT INFORMATION

In addition to the portfolio accounting information noted above, institutional investment managers include
portfolio management information in their quarterly reports to investors. Some institutional investment
managers also provide a monthly portfolio management report, but it tends to contain only selective information,
since a more in-depth report is expected and delivered to the investor with the quarterly report.
The portfolio management information portion of the quarterly report typically includes return data, holdings data,
attribution analysis and market commentary. It is important to note that, although the focus of the quarterly report
is on the most recent quarter, it is standard for the portfolio manager to include all portfolio return information and
associated statistics on a yearly, quarterly and monthly basis since inception of the relationship with the particular
institutional investor. This is appropriate and necessary, because institutional investment managers are typically
assessed not only on their most recent performance, but also on the value they have added since the start of their
relationship with a particular investor.
The portfolio management information listed above is also included in the presentation the portfolio manager
makes to the institutional investor’s investment committee.

FRONT OFFICE BEST PRACTICES

As discussed in Chapter 4, an institutional investment management firm’s good organizational design uses the
separation of duties principle. This design principle is especially important when considering the processes and
procedures related to fund performance measurement, and the adherence to investment guidelines and restrictions
for each portfolio the firm manages.

PERFORMANCE MEASUREMENT
For an institutional investment manager, it is imperative that it accurately calculates investment fund performance.
In order to accomplish this, all income, gains and losses, as well as end-of-period security holding valuations, must
be accurate. The accuracy of performance results is important not only to a firm’s current investors, but also to the
firm itself, since these performance numbers undoubtedly become integrated into its reporting to third parties, such
as the financial press, pension consultants and, of course, current and potential institutional investors.
A firm’s eventual success depends to a great degree on its portfolio performance history. As well, for most
institutional portfolio managers, their variable compensation is directly dependent on the performance of the
respective funds for which they are responsible. Accordingly, there is a potential conflict of interest if a portfolio
manager is solely responsible for calculating the rates of return for the portfolios they are managing.
Good organizational design requires that the middle office staff is solely responsible for calculating the periodic
rates of return for a firm’s various portfolios. If the separation of duties principle is used in a firm’s organizational
design, the middle office staff is independent of the front office staff, including its chief investment officer. The
middle office staff report directly to a firm’s most senior executive. This organizational design and approach to
calculating fund returns represents a best practice within the institutional investment industry. (See Chapter 6 for
more information on an investment management firm’s middle office.)

DUAL SIGNATURES
Most institutional investment management firms allow — and usually expect — their senior portfolio managers to
manage their respective portfolios with freedom, providing, of course, that they do so with strict adherence at all
times to the investment guidelines and restrictions established for each of the various portfolios the firm manages.

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Accordingly, senior portfolio managers will initiate security transactions without pre-approval from their supervisor.
This is an accepted practice in the institutional investment management industry.
However, it is an industry best practice that all completed security transaction confirmations (“tickets”) be signed
by two approved individuals in the portfolio management group. The first signatory is the portfolio manager who
originated the security transaction, while the second is usually either the portfolio manager’s supervisor or another
portfolio manager who is a peer.
It is good operational practice to develop a security transaction “signing authority matrix” that clearly articulates
which individual in the front office is allowed to co-sign a particular portfolio manager’s security transaction
confirmations. This signing authority matrix should be approved by the firm’s most senior management committee
and must be kept current to reflect changes in portfolio management staff, as well as any changes in the individual
investment mandates the firm manages.
This practice reduces the potential for transactions to occur that might not be approved or appropriate for a
particular portfolio. It also helps to avoid situations where there are errors in the tickets, such as an incorrect
security or an incorrect pricing or amount.

EMPLOYEE PERSONAL TRADING

It is very important for firms to have a clearly written policy regarding the personal investing activities of pertinent
staff. Firms are left to decide which particular personnel are required to abide by this personal trading policy. Some
firms take a blanket approach, so that the policy covers all employees. Other firms consider which staff members
have access to their trading plans and strategies, and limit their policy to these particular employees.
Policies vary by firm, but as a best practice, most firms abide by the following process:
• The employee contacts the appointed personnel, which is usually the designated person in the firm’s compliance
department, and requests written pre-clearance to do a trade for their personal account. Best practice requires
that this pre-trade permission be obtained not only for the employee, but also for all family currently living with
them. The request for pre-trade clearance includes the name of the security, whether it is a buy or sell, and the
name of the account in which the planned security transactions will occur.
• The compliance department then reviews the firm’s restricted list or other proprietary information regarding
its planned security trading activities, and decides whether to permit the trade. Permission is granted in written
form and includes all of the information about the requested trade. Note that, when granted, this permission is
normally for a fixed period of time — usually just for the date on which the permission is granted. After receiving
permission, the employee will then execute the trade with their own broker.
• As part of this pre-trade personal trading clearance policy, the employee must also ask the brokerage firm
with which they hold a personal account to send copies of all trade confirmations and month-end account
statements directly to the firm’s compliance staff. The compliance staff will then compare the employee’s actual
trading activities with the record of pre-trade clearances issued to the employee during the previous month.

INVESTMENT MANAGEMENT AGREEMENT

In business, it is always good practice for the two parties to a commercial transaction or relationship to document
the terms and conditions governing their business relationship through a properly executed contract.
The contract that governs the relationship between an institutional investment manager (the “Advisor”) and its
institutional investor client (the “Client”) is commonly referred to as an investment management agreement.
Although each institutional investment management firm has its own unique investment management agreement,
good contract design incorporates the following salient terms and conditions:
• The Advisor’s appointment and acceptance (gives notice of the appointment)
• The Advisor’s responsibilities or duties

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• The Client’s investment objectives and restrictions, which are laid out in an appendix to the contract — see
“Appendices” at end of this list
• The relationship to parties, which confirms that the firm is a legal entity that is independent of the investor
• The description of the standard of care the firm will exercise when discharging its duties under the terms of the
agreement
• The method of execution of portfolio transactions
• The details on the custody, settlement, delivery and receipts of securities
• The types of reports to be submitted to the Client
• The compensation, including fees and expenses, which are laid out in an appendix to the contract — see
“Appendices” at end of this list
• The Advisor’s representations and warranties
• The Advisor’s liability and indemnification
• The treatment of personal information and privacy
• The rules governing termination
• The general provisions; for example, governing law, severability, amendments, risks and assignments
• Appendices
The Client’s investment objectives and restrictions
« Allowable investments
« Diversification restrictions
« Investments not permitted
« Investment strategies not permitted
« Foreign exchange hedging, including how much and when
Compensation: Fees and expenses
« Investment management fees, including the level and scale
« Performance fees, if applicable

Typically, some degree of negotiation and eventual modification of the contract occurs between institutional
investors and their investment managers. However, on the whole, contract terms are fairly standard throughout the
Canadian institutional investment management industry.

INVESTMENT GUIDELINES AND RESTRICTIONS

The first appendix noted above — “The Client’s investment objectives and restrictions” — contains the various
investment guidelines and restrictions that the investment manager will adhere to on a continuous basis while
managing a particular investment mandate. It is critical that both the investor/client and the institutional
investment management firm have a very clear understanding of the various mutually agreed upon limitations that
govern the management of the investor/client’s portfolio.
It is certainly an industry best practice to include such an attachment to an investment management agreement.
These investment guidelines and restrictions serve a number of potential benefits, including:
• Helping the investment manager explain its particular investment style and strategy, since the guidelines and
restrictions should be consistent with it. They help explain the uniqueness of the firm’s investment strategy.

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• Helping the investment manager explain future investment performance. This is very important, especially if
investment results deteriorate. Explaining investment results is made easier when the investment process was
conducted within mutually agreed upon terms.
• Protecting against a claim from an investor should investment results be particularly poor (in the investor’s
opinion). As long as the investment strategy was conducted in accordance with the guidelines and restrictions,
the likelihood of the firm paying a claim is low.
• Demonstrating that the investment strategy and process is structured, therefore helping increase the
probability that investment performance will be more consistent and less volatile compared to another firm’s
results.

The investment guidelines and restrictions are integrated into the software the firm uses to test a planned trade’s
compliance before the institutional investment manager assumes responsibility for the new investor’s assets. The
pre-trade compliance test ensures that all contemplated security transactions are made within the investment
guidelines and restrictions for a particular portfolio or mandate.

GETTING CLIENTS
As discussed in Chapters 3 and 4, there are essentially three basic types of institutional clients:
1. Institutional investors (non-mutual fund clients)
2. Mutual fund sponsors
3. Individual investors (high-net-worth clients)

Outlined below are the sales and marketing processes and strategies for each of these types of clients. Those for the
institutional and mutual fund investors are somewhat similar, but the ones for individual investors are unique.

INSTITUTIONAL AND MUTUAL FUND SPONSORS

The institutional investor marketplace is extremely large in terms of assets under management and has shown
great growth over time. However, the number of institutional investors has shown very little growth over time.
This pattern is typical of an industry that offers excellent economies of scale and is therefore a prime candidate
for merger activity and other forms of business consolidation. For institutional investment managers, new asset
management opportunities arise in the following situations:
• The institutional investor is dissatisfied with their current institutional investment manager and is therefore
starting a search for a replacement investment manager.
• The institutional investor is expanding their investment fund product mix and has decided to add new
investment managers with skills in these new mandates.

Accordingly, the majority of institutional investment management firms adopt sales and marketing strategies that
are based on these two main factors that motivate institutional investors to hire new institutional investment
managers. There are three primary steps in this institutional sales and marketing process, which are outlined in more
detail in the following sections:
1. Creating sales and marketing literature
2. Determining a sales and marketing approach
3. Preparing a presentation to potential investors

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CREATING SALES AND MARKETING LITERATURE

Sales and marketing materials introduce the firm to potential new investors and tend to focus on four main topics:
1. The owners/portfolio managers, including a brief history of the firm; the current ownership structure; an
organizational chart (both the overall corporate organization and the portfolio management organization); the
total number of employees, as well as a breakdown of the employees involved in each major functional area
of the firm; and a description of any significant partnerships or business relationships with other institutional
investment management firms.
2. The firm’s investment mandates, including a brief summary of each investment strategy and the amount of
assets managed in each respective investment.
3. The firm’s investment strategy and investment decision-making process, which highlights the fundamental or
technical investment approach, the key factors that are incorporated in the strategy and why they can lead to
superior investment decisions and returns, and a list of external databases and third-party analytical tools or
research used.
4. The firm’s portfolio performance track record, which consists of the growth history of its assets under
management by investment mandate and by year; summary details regarding the firm’s current investor mix,
including the number of institutional, mutual fund and individual investors, as well as the total assets managed
for each type of investor; the firm’s portfolio performance history, including rate of return data by mandate
and by year, quarter and month since inception; rate of return statistics, including volatility, correlation, beta
and relevant ratios; and the current portfolio value at risk.

DETERMINING A SALES AND MARKETING APPROACH

There are two basic sales and marketing approaches for institutional investors:
1. Direct contact
2. The use of pension consultants

The first approach entails a designated employee from the institutional investment management firm contacting
target institutional investors directly. At a smaller firm, the employee representing the firm will either be a
partner/portfolio manager, while at a larger firm they will be a senior sales and marketing person. The person who
is contacted at the institutional investor will normally be a very senior executive or the most senior executive
responsible for investment management.
This first sales and marketing contact tends to be a phone call alone or a letter that introduces the institutional
investment management firm and states that a follow-up call will be made to determine if an opportunity exists.
If this first contact by phone or letter elicits interest from the investor, the firm will send a package of materials
containing the information on the four topics outlined above to the investor’s contact.
The institutional investment manager’s representative places a follow-up call to the contact to see if they have
reviewed the materials and would like to meet to receive a presentation by the firm. At this stage, the following
scenarios can occur:
• If the contact agrees, arrangements are made for a meeting.
• If the contact does not agree to a presentation, then one of two routes is taken, where the choice depends on
the institutional investor’s potential future needs.
• If it seems the firm cannot meet the investor’s investment management needs, then no further contact is made.

If it seems that there might be a future opportunity, the institutional investment manager’s representative keeps
in touch with the potential investor by sending quarterly updates about the firm, including its growth and fund
performance statistics, to keep the door open.

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The second sales and marketing strategy for institutional investors is the use of pension consultants. Often, the
direct sales and marketing approach is supplemented by establishing contact and rapport with one or more pension
consultants. (The role of pension consultants was discussed in detail in Chapter 3.) Pension consultants often play
an integral role in the hiring of new institutional investment managers, particularly by small to medium-sized
pension plans and endowments. Their services are also used by large pension plans that do not have the internal
resources to conduct new investment manager searches.
In order to provide the highest level of service to current and potential clients, pension consultants invest heavily
in building detailed quantitative and qualitative databases of major participants in the institutional investment
management industry. To accomplish this, they do three main things:
1. Complete and maintain up-to-date and detailed due diligence files on institutional investment management
firms.
2. Interview new institutional investment managers and maintain a rapport with established managers.
3. Receive detailed portfolio management information from the institutional investment management firms
included in their investment manager database. This data includes month-end portfolio holdings, periodic
rates of return, the assets in each type of investment mandate and the number of investors or clients.

The primary objective of this particular sales and marketing approach is to have a number of pension consultants
agree to conduct a due diligence review of the firm. Afterwards, the firm becomes part of the consultants’
proprietary database of institutional investment managers. The long-term goal of this approach is to have the firm
included in pension consultants’ short lists of institutional investment managers for their pension plan and other
institutional investor clients, when these clients hire consultants to help them search for and hire a new manager.

PRESENTING TO POTENTIAL CLIENTS

The next major step in the sales and marketing process is to be included in the short list of institutional investment
managers that an institutional investor will interview. Usually, this list only includes four to six firms and was
developed after the investor carefully considered its needs, as well as all of the firms’ capabilities. The firms included
in the short list are asked to make a presentation to the institutional investor’s appropriate committee, which is
usually known as the investment committee.
These presentations are normally about a half hour in duration and are made in person to all of the institutional
investor’s investment committee members, as well as one or more representatives from the pension consulting firm
(if they are involved in the investment manager search). Most pension plan investment committees will try to have
a single day’s worth of meetings in which all of the short-listed candidates do their presentations.
The institutional investment management firm will usually be represented by two or three individuals, including
the head of sales and marketing and one or two senior portfolio managers. The presentation will include all of the
information from the sales and marketing literature plus any supplemental information the investment committee
requested.
After the candidates have completed their presentations, the members of the investment committee will meet
in private with the pension consultant to review the presentations. Often, the selection of a new investment
manager can be decided quite quickly, while in other situations, it might be necessary to have a second round of
presentations or meetings with two or three of the investment managers that participated in the first round of
presentations.
Generally, the governance practices of most institutional investors do not permit the sub-committees responsible
for investment management affairs to unilaterally appoint or hire a new investment manager. After the investment
committee completes the due diligence and interview process, it will deliberate to agree upon one (or sometimes
two) institutional investment managers to be recommended to their board of trustees for final approval. Because
the hiring of new investment managers is a relatively infrequent process, many institutional investors arrange for
the investment committee to have its requisite meetings to hear presentations and its follow-up meetings just

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before the regularly scheduled (usually quarterly) board of trustee meetings. This scheduling potentially shortens
the period between a candidate’s presentations and the announcement of the new investment manager.

INDIVIDUAL INVESTORS
A number of institutional investment management firms offer some of their investment mandates to individual
investors. Under regulatory requirements, these individuals must qualify as “exempt” investors. In addition, most
firms set a minimum initial investment threshold of $1 million, $2 million or even higher. Institutional investment
management firms that cater to these investors usually hire a team of individuals who market to and service only
this type of investor. These individual clients are generally offered the choice of either a managed account structure,
which is more expensive to operate, or units of one or more of the manager’s pooled fund products.
Individual investors receive reports that are very similar to those received by a firm’s institutional investors. The
number of annual client service meetings with an individual investor is generally related to the amount of money
they have invested with the firm. Usually, the firm offers the investor meetings with a representative on a quarterly
or semi-annual basis.
Some firms have a deliberate development strategy to grow their individual investor business. A firm with this
strategy may believe that individual investors can be a more stable book of business over time than institutional
investors. This is based on the assumption that institutional investors represent a bigger business risk should a firm’s
portfolio performance deteriorate. In general, these firms believe that institutions will more quickly terminate an
underperforming investment manager than individual investors will, and that an institution’s decision to terminate
usually involves materially larger amounts of assets leaving the firm.

TIMELINE FOR GETTING CLIENTS

The length of time it takes for an institutional investment management firm to be awarded its first mandate from
an institutional investor can vary substantially and depends on a number of factors, including:
• The length of time the firm has been in business
• The consistency and competitiveness of the firm’s portfolio performance over that period of time
• The firm’s sales and marketing capabilities

It is rare for a new institutional investment management firm with less than a three-year track record to secure an
institutional investor as its first client, unless its senior portfolio managers are able to effectively “transport” their
respective personal investment performance track records from their prior places of employment. For three main
reasons, three years is generally considered the minimum amount of time a firm must be in operation in order to
receive consideration. Potential institutional investors and pension consultants generally regard three years as the
minimum time needed to:
• Evaluate the robustness of the firm’s investment management strategy;
• Determine whether the firm’s partners can operate all aspects of the firm properly and effectively; and
• Test the cohesiveness of the partnership.

Of course, once the institutional investment management firm has obtained “critical mass” and has some
institutional investor clients, the typical time period between winning new investment mandates will shorten
substantially, assuming the firm’s investment performance remains competitive and its sales and marketing staff are
effective.
Medium- to large-sized institutional investment management firms can be involved in a number of new investment
manager searches at any point in time, and it is common for large firms to win new institutional investor mandates
on a monthly basis.

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It should be kept in mind that institutional investment management firms not only strive to increase the number
and breadth of their institutional investors, but to also increase their assets under management from each of their
existing investors.
Once a firm has been successfully awarded the investment mandate from an institutional investor, the only
remaining step is the contracting process. From a business perspective, it is very important that the firm has suitable
and comprehensive agreements pertaining to all aspects of its business relationships with its clients. An investment
management agreement, outlined in the previous section entitled “Front Office Best Practices”, is essential.

LOSING CLIENTS
All portfolio managers should be aware of the main causes of an investor’s disappointment and it can lead to the
termination of an investment management contract. Contract terminations tend to be a result of one or both of the
following factors:
• Weak investment performance (relative to peers)
• Low-quality client service

WEAK INVESTMENT PERFORMANCE

When hiring an institutional investment management firm, institutional investors tend to prefer firms that have
operated for a minimum length of time, preferably longer than three years. The longer the firm has been in business,
the more comfortable and confident the institutional investor is with the decision to hire the firm. Similarly, the
decision to terminate a firm is also based on results over a period of time.
Institutional investors analyze the investment performance of their investment managers with great diligence.
An institutional investor’s investment committee formally reviews performance results for each institutional
investment management firm on at least a quarterly basis within the context of the performance of its peers. Peer
investment manager performance surveys are produced by a number of larger pension consulting firms and
contain sufficient information to evaluate the effectiveness and competitiveness of an individual firm’s investment
process.
Within the industry, it is common practice for an institutional investor to put an institutional investment
management firm on notice when its investment committee has become concerned that the firm is not meeting
the investor’s portfolio performance standards. Median performance is accepted by most institutional investors and
does not usually result in any notices or in the firm’s termination. However, performance that slips deep into the
third quartile or the top of the fourth quartile in a performance survey for two to four consecutive quarters will often
result in a discussion with the firm, which in turn might place it on notice.
The decision to dismiss a firm will partly depend on how effective it is at explaining its results in relation to the
investment strategy it employs. Most institutional investors and pension consultants understand that investment
results are affected by the choice of investment strategy, as well as by its execution, and will incorporate this
knowledge in their deliberations about the firm.
Some institutional investors will also consider the absolute amount of a firm’s underperformance relative to the
median performance results for the appropriate peer performance survey or investment manager universe. In some
environments, the difference in the rate of return between the median performance and the bottom of the third
quartile might be as small as 50 basis points of an annual rate of return, while in other market environments, this
particular performance spread might be as large as 3% to 5% on an annual return basis. The size of this absolute
spread often affects the institutional investor’s decision to give a warning or termination notice to a firm.
The situation discussed above deals with the more common situation where a firm has, at best, mediocre results
and is somewhat uncompetitive in comparison to its peers over time. However, unfortunately, there are also

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situations where a firm experiences extremely poor performance over a short period of time. In these instances, the
termination timeline could be shortened substantially.
Normally, the firm will be requested to meet promptly with the institutional investor in order to explain in detail the
precise sources of its extreme underperformance. It is very important that the performance be carefully analyzed in
terms of the agreed-upon investment guidelines and restrictions for the particular portfolio. Termination is usually
immediate if it is concluded that the firm failed to operate precisely in accordance with the investment guidelines
and restrictions at all times.

POOR CLIENT SERVICE

Client service is a very important aspect of the institutional investment management relationship. Institutional
investors tend to be very precise with regard to the support and information they need and expect from their
various institutional investment management firms.
Most institutional investors will not tolerate client service that is below standard quantity and quality, and good
institutional investment management firms constantly seek feedback as to an investor’s level of satisfaction
with their service. Certainly, poor investment results will be tolerated for a shorter period of time if they are
accompanied by poor client service.

TERMINATION PROCESS
As noted above, the first step in the termination process is normally the institutional investor’s communication to
the institutional investment management firm that it has been placed on notice. Notice periods are not necessarily
defined, but it is typically understood that the firm may have between at a minimum two quarters and at a
maximum one year to deliver improved performance results.
Failure to meet these expectations will result in the notice of termination of the investment management
agreement. This notice is almost always immediate and will be delivered via telephone directly from the
institutional investor, as well as by written confirmation delivered via same-day courier.
Normally, the notice of termination also includes the clear and precise instruction that the institutional investment
management firm must immediately terminate all trading activities for the investor’s portfolio.

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 CHAPTER 5 | THE FRONT OFFICE 5 • 21

SUMMARY
After completing this chapter, you should be able to:
1. Describe the typical organizational structure of a modern institutional investment management firm’s front
office.
In the modern institutional investment management firm, the front office has the following four main areas
of responsibility: portfolio management, trade execution, sales and marketing, and client service.

2. Explain the key roles and responsibilities of portfolio management staff.

Chief investment officer: Has overall responsibility for a firm’s portfolio management activities.
Head of equities: Has overall portfolio management responsibility for all of the equities a firm manages.
Head of fixed income: Has overall responsibility for the portfolio management of all of a firm’s fixed income
and money market securities.
Portfolio managers: Are responsible for making the day-to-day investment management decisions that
affect the portfolios for which they are responsible.
Assistant portfolio managers and investment analysts: Generally, assistant portfolio managers cannot
execute any security trades, or if they are permitted to do so, only within very limited parameters and only
with a portfolio manager’s prior approval. Investment analysts are not allowed to execute any security
trades.

3. Explain the benefits of good security trade execution.

The primary objective of security trade execution is to obtain the best execution — meaning, the best prices
at which securities are bought or sold.

4. Describe an institutional investment management firm’s typical sales and marketing strategy.
Primary responsibility is to effectively communicate the firm’s marketing message to potential investors in
order to accumulate assets for the firm.
There are three primary steps in this institutional sales and marketing process:
1. Creating sales and marketing literature
2. Determining a sales and marketing approach
3. Preparing a presentation to potential investors

5. Describe the role that client service plays in both retaining and growing a firm’s assets under management.
The primary objective of client service is to provide current investors with the appropriate amount of verbal
and written communication regarding the management of their assets.
Institutional investment management firms consider client service important for three primary reasons:
« Client service demonstrates to current and potential future investors a firm’s level of commitment to the
delivery of an entire institutional investment management service.
« Client service can be a “defensive” mechanism that helps a firm retain investors in the event that its
portfolio performance starts to deteriorate.
« Client service reduces the amount of time a portfolio manager is out of the office presenting and meeting
with current and potential investors.

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6. Identify the key terms and conditions included in an institutional investment management agreement.
An investment management agreement contains various terms and conditions such as the Advisor’s
appointment and acceptance; the Advisor’s responsibilities or duties; the details on the custody, settlement,
delivery and receipts of securities; the rules governing termination; and the appendices, which contain the
Client’s objectives and restrictions, as well as fees and expenses.

7. Explain the best practices for risk control and securities trading procedures.
Best practices include dual signatures, employee personal trading policies and pre-trade compliance tests.

8. Identify the main reasons why institutional investment management contracts are terminated.
Contract terminations tend to be a result of one or both of the following factors:
« Weak investment performance (relative to peers)
« Low-quality client service

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 The Middle and Back Offices 6

CONTENT AREAS

Overview of the Middle Office

The Middle Office

The Back Office

LEARNING OBJECTIVES

1 | Describe the organizational structure of a modern investment management firm’s typical middle
office.

2 | Outline the main roles and responsibilities of an investment management firm’s compliance
function.

3 | Describe the straight-through processing (STP) system and explain why it is important for
investment management firms to use this type of portfolio data management system.

4 | Outline the main roles and responsibilities of an investment management firm’s legal function.

5 | Explain why it is important for an investment management firm’s operations to be audited.

6 | Explain the difference between fund accounting and unitholder record-keeping.

7 | Explain a fund’s net asset value (NAV) and describe what the consequences are for its manager if the
fund has an incorrectly calculated and stated NAV.

8 | Describe the primary roles and responsibilities of an investment management firm’s back office.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

audit portfolio turnover

bearer form pre-trade compliance testing

compliance straight-through processing (STP)

fund accounting trading philosophy

net asset value (NAV)

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 CHAPTER 6 | THE MIDDLE AND BACK OFFICES 6•3

INTRODUCTION
This chapter introduces the middle office’s four main areas and explains its key interfaces, information flow and
best practices. Next, we explain the back office’s key interfaces and information flow. The chapter concludes with an
explanation of the back office’s key best practices.

OVERVIEW OF THE MIDDLE OFFICE

A modern institutional investment management firm’s middle office has the following four main areas of
responsibility:
1. Compliance
2. Legal
3. Auditing
4. Accounting

These functions are shown in Figure 6.1 below.

Figure 6.1 | The Four Main Functions of the Middle Office

Middle Office

Compliance Legal Auditing Accounting

A very large investment management firm has a middle office structure that is very similar to the one shown in
Figure 6.1. Each of the four main functions has its own specialized staff and reports to its functional head: the chief
compliance officer, the chief legal officer, the chief auditor and the controller, respectively. Generally, these four
middle office functional heads report directly to the firm’s president, who is also the firm’s ultimate designated
person (UDP). The only exception to this reporting structure is when a firm also has a chief operating officer. In that
situation, all of the middle office functional heads, with the exception of the chief compliance officer, report directly
to the chief operating officer. The chief compliance officer still reports directly to the president/UDP and often has
a dotted-line reporting relationship to the chief operating officer. In small- to medium-sized firms, some of these
functions are consolidated or even outsourced, with the only exception being the compliance function, which by
regulation must be staffed by an employee of the firm.
The final organizational component of an investment management firm is the back office, where trades are settled.
Historically, the back office was referred to as “the cage”, since security transaction settlements took place at the
custodian’s security vault. Custodial and safekeeping staff were generally located in very close proximity to the vault
and worked in a physically secure office with metal bars or a wire cage structure, hence the use of the term cage.
This level of security was necessary since transactions were settled by exchanging cheques for securities that were
often not registered and in bearer form. In legal terms, bearer form means the security certificate being exchanged
at the cage was negotiable and payable to the bearer, even if it was $100 million in Government of Canada Treasury
Bills. Nowadays, virtually all security transactions are settled electronically on a global basis 24 hours a day.

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This chapter discusses the operations of a modern-day investment management firm’s middle and back offices,
including their main roles and responsibilities, best practices and how information flows among staff.

THE MIDDLE OFFICE

THE COMPLIANCE FUNCTION

The compliance function ensures a firm is being run in such a way that it is abiding by the rules and regulations set
by securities regulators, the terms prescribed in its investment management agreements with investors and the best
practices it has established. The compliance function’s primary objective is to ensure that all of a firm’s products,
operations, and sales and marketing practices are in compliance with all security regulations and applicable laws.
In Chapter 4, it was noted that the various provincial securities regulators require that only one individual at
an investment management firm or exempt market dealer should act as the designated compliance officer.
Accordingly, a firm must be structured in such a way that all compliance staff report to, and all related activities be
reported to, the designated compliance officer.
The roles and responsibilities of a firm’s compliance function focus on three primary areas:
1. Licensing and regulatory reporting
2. Sales and marketing, and client service
3. Portfolio management

LICENSING AND REGULATORY REPORTING

The first area of focus for the compliance function is licensing and regulatory reporting, which ensures that both a
firm and its employees have the required licences and registrations to offer their investment products and services.
Regulatory licences are renewed on an annual basis, so it is the compliance department’s responsibility to ensure
that all of the appropriate renewal applications are properly completed and submitted to the respective securities
regulators on time.
Compliance staff must also ensure that all securities regulators are informed of an individual registrant’s departure
no more than five days after they have left the firm. Likewise, they must secure registrations — portfolio manager
(PM) — for all of the firm’s new employees, or for those employees who have been promoted to the levels of
portfolio management responsibility that require registration.
Normally, compliance staff are the primary point of contact with securities regulators, so they are also responsible
for ensuring that the firm and its senior management have the most current regulatory information. They do so by
ensuring that senior management has received, read and understood all relevant communiqués from regulators, and
that these communiqués are then communicated on a timely basis to the relevant staff.
Provincial securities regulators also require registrant firms to file various interim reports on a monthly basis.
These reports can cover a wide range of topics, from calculations of the firm’s net free capital, to confirmation of
compliance to domestic and international laws that are designed to prevent terrorists from using the global financial
system to further their activities.1, 2, 3

1
Criminal Code (R.S., 1985, c. C-46). Department of Justice, Government of Canada. Available online at:
http://laws-lois.justice.gc.ca/eng/acts/C-46/.
2
Regulations Implementing the United Nations Resolutions of the Suppression of Terrorism (RIUNRST).
3
United Nations Al-Qaida and Taliban Regulations (UNAQTR), Section 5.1.

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 CHAPTER 6 | THE MIDDLE AND BACK OFFICES 6•5

DIVE DEEPER

Compliance with the Criminal Code

The Criminal Code of Canada includes laws pertaining to terrorist financing and terrorism-related
property. Specifically, section 83.1 of the Code reads:
Every person in Canada and every Canadian outside Canada shall disclose forthwith to the Commissioner
of the Royal Canadian Mounted Police and to the Director of the Canadian Security Intelligence Service
a. the existence of property in their possession or control that they know is owned or controlled by or
on behalf of a terrorist group; and
b. information about a transaction or proposed transaction in respect of property referred to in
paragraph a).

Section 83.11 states that “entities authorized under provincial legislation to engage in the business of
dealing in securities, or to provide portfolio management or investment counselling services” must
determine regularly whether they are in possession or control of any property listed under 83.1.
Section 83.12 states that the fine for contravening these laws is up to $100,000 or imprisonment for up
to one year (or both) for a summary conviction, and upon indictment, imprisonment for up to 10 years.*

* Criminal Code (R.S., 1985, c. C-46). Department of Justice, Government of Canada. Available online at
http://laws-lois.justice.gc.ca/eng/acts/C-46/.

SALES AND MARKETING, AND CLIENT SERVICE

The second area of focus for the compliance function is sales and marketing, and client service, which ensures
that all of a firm’s written and verbal communications, as well as its dealings with current and potential investors,
conform to appropriate regulations.
The compliance department must receive written confirmation that any third-party distributors used by the firm
have the appropriate securities registrations to sell its products and services to particular investors. The department
must ensure that the information included in the firm’s sales and marketing materials is presented in a manner that
is consistent with regulations and industry standards. This is also the case for scripted materials for use during sales
and marketing presentations to potential investors. Some examples of the type of information that compliance staff
need to review are as follows:
• Whether the firm is making any inferences or promises regarding the future rates of return for its portfolios
• Whether the portfolio rate of return calculations are in strict adherence to accepted practices. Any deviations
from these practices must be described and included in the materials. Two important questions compliance
staff will ask include:
Are the rates of return calculated and presented in a manner consistent with Global Investment Performance
Standards (GIPS)? (Established by the CFA Institute, GIPS is the highest standard globally for establishing the
basis and methodology pertaining to the calculation and presentation of portfolio performance results.)
Are the rate of return figures presented on a gross basis — that is, on a pre-fee basis — or are they net of all
fees related to the fund’s management?

In addition, the compliance department must review and approve all new forms of investment management
contracts and distribution agreements to be executed with third-party distributors. They must also ensure that, prior
to executing investment management agreements, written acknowledgments have been received from potential
investors confirming that they satisfy the regulatory requirements to qualify as exempt or accredited investors.
In terms of client service, compliance staff must also ensure that all reports and communications with current
investors are presented in a manner that is consistent with regulations and industry standards.

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PORTFOLIO MANAGEMENT
The third area of focus for the compliance function is portfolio management. It is critical that each of the firm’s
investment portfolios is managed in a manner that complies with applicable guidelines and restrictions. The
compliance staff must ensure that each of the firm’s investment mandates has its own unique set of written
investment guidelines and restrictions, and that they form part of the investment management agreement executed
for each portfolio. The investment guidelines and restrictions for each portfolio are a combination of the following:
1. The investment restrictions stated in the applicable securities regulations.
2. The investment guidelines and restrictions negotiated with each investor.

EXAMPLE
An example of an investment restriction emanating from securities regulators would be the maximum permitted
investment in any one security issuer of 10% of a mutual fund’s net asset value (NAV), as set forth in National
Instrument 81-102.

These restrictions must be combined with the investment guidelines that a specific investor has agreed to and that
form part of the firm’s investment advisory agreement with all of its investors.
In order to ensure these investment restrictions and guidelines are followed on a continuous basis, it is an industry
best practice to incorporate these guidelines and restrictions into software that will perform pre-trade compliance
testing of contemplated securities transactions. Pre-trade compliance testing ensures that securities trades are
compliant with all regulations pertaining to both the conduct of capital markets and a particular fund, as well as
the investment guidelines and restrictions that are agreed upon with investors prior to the execution of a trade.
Non-compliant trades, which are captured by pre-trade compliance testing, can be costly for an investor — and
accordingly, an investment management firm — since they can have severe regulatory, taxation and legal penalties.

STRAIGHT-THROUGH PROCESSING
It is an industry best practice for investment firms to use portfolio management software that incorporates a
straight-through processing (STP) system. This type of security trade processing and portfolio management
software provides one continuous real-time investment management database that links a firm’s front, middle and
back offices.
Essentially, an STP system is a single information database that is designed around all of the necessary steps
required to properly execute, record and settle a security trade. The STP system operates on a real-time basis and
various individuals at a firm are granted appropriate and limited access to the system depending on their individual
job requirements and informational needs.
The following list includes those individuals who have access — albeit restricted, as deemed appropriate — to the
STP system and use it exclusively to perform their daily portfolio management and related activities:
• Portfolio managers
• Traders
• Compliance officers
• Risk managers
• Back-office and trade settlement personnel
• Sales, marketing and client service staff
• Senior management (president, chief investment officer)

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What follows is a summary of the various STP system processing steps involved in a security transaction:
1. A portfolio manager enters the details of a contemplated security transaction into the STP system. This will
normally include information such as the name or ID of the security, the size of the trade, a price limit and a
list of the various portfolios for which the planned transaction will be executed.
2. The STP system will then immediately determine whether the contemplated security transaction is in
compliance with all of the various regulations and investment guidelines/restrictions that pertain to each and
every portfolio involved.
The STP system will also ensure other portfolio parameters, such as the availability of sufficient cash to pay
for the security purchase, or in the case of a security sell transaction, that a sufficient amount of securities is
available so that a short sale transaction does not occur by error.
If the planned transaction passes all of the various compliance tests, the trade is approved and then routed to
the trader’s desk for execution. If the planned transaction fails any of the applicable compliance tests, the trade
is returned to the portfolio manager’s input screen and the potential compliance violations are identified. The
portfolio manager will then adjust the trade so that it is in accordance with the compliance tests.
3. Upon receiving the trade, the trader places it, either verbally or through an external electronic trading system,
and immediately notifies the STP system that the trade has been placed.
4. Upon execution, the trade is then entered into the STP system either manually (in the case of a verbally
communicated trade) or electronically (in the case of a trade placed through an electronic system).
5. The executed trade is then transmitted electronically to four parties:
The portfolio manager (who initiated the trade)
The firm’s back office for trade settlement
The firm’s custodians
The trade’s counterparty (broker/dealer)

STP systems are designed to avoid human errors associated with securities trading, settlement and record-keeping
activities. The real-time nature of STP systems, coupled with the robustness of their pre-trade compliance module,
ensures that security transactions are in accordance with all applicable regulations, and that investment guidelines/
restrictions are permitted to be executed.
Securities regulators and a firm’s internal and external auditors also strongly encourage the use of STP systems,
since they dramatically improve a firm’s overall effectiveness and efficiency. In addition, STP systems normally
include modules that specifically provide information about a firm’s investment management activities in a format
that aids its regulators, as well as internal and external auditors, in their audit and review activities.
Figure 6.2 provides a simplified schematic of the key steps associated with a security transaction. State-of-the-art
STP systems provide all of the electronic interfaces between these steps. They also have pre-trade compliance, trade
execution, trade settlement, portfolio accounting and audit modules.

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6•8 PORTFOLIO MANAGEMENT TECHNIQUES

Figure 6.2 | Key Steps in a Security Transaction

Portfolio Trade
Management Origination

Rejected
Trade

Pre-trade
Compliance
Compliance Testing

Approve
Trade
Investment Trade
Trading Execution
Dealer

Trade
Custodian Back Office Settlement

Portfolio
Accounting Accounting

THE LEGAL FUNCTION

The primary objective of an investment management firm’s legal function is to help ensure the firm has structured
its business affairs properly from a legal perspective — that is, the firm cannot get into a situation where it could
be held financially liable to another party. Investment management is a multidisciplinary activity and, accordingly,
a firm must use the services of a number of specialized third-party service providers. It is important that a firm has
competent legal counsel to ensure that all of these services are properly contracted for.
Investment management firms have numerous requirements for competent legal support. First, as with any
business, they require legal support for the following activities:
• Business registration and incorporation
• Business owner/partnership agreements
• Employment agreements
• Distribution agreements
• Investment management agreements
• Fund structure creation:
Limited partnerships
Trusts
Managed account agreements
• Review of service contracts from third-party service providers:

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Landlord
Financial market data vendors, such as Bloomberg and Thomson Reuters
Portfolio management software, such as an STP system
Financial and portfolio accounting software

Generally, an investment management firm’s decision to staff an internal legal function depends on its type and size:

Is the firm a subsidiary In most instances where a firm is a wholly owned subsidiary of a larger company, such as
of a larger corporation? a bank, mutual fund company or life insurance company, it will normally have a service
agreement in place for the parent company to provide suitable legal support.

Is the firm If the firm is independent, the decision to fund an internal legal resource will be based
independent? on its size. Of course, the larger the firm is, the more likely it is to have permanent legal
staff on payroll. The major factor is the cost comparison of having to pay a third-party
legal firm versus having a permanent full-time lawyer and support staff on payroll.

Legal resources are most needed during a firm’s start-up phase, when it is creating and launching new funds or
products, and when it is entering new markets with new distribution partners. Otherwise, investment management
firms generally do not require many legal personnel in its day-to-day operations.
One final area the legal function should be involved with is investor dissatisfaction. A firm should have processes
in place to ensure that all instances of investor dissatisfaction or complaint come to the attention of its legal
department. Legal staff must be advised on a timely basis of all developments with dissatisfied investors.
In medium-sized firms, it is quite common for legal and compliance staff to form one organizational unit. This
arrangement generally makes good sense, since a number of the skills required to deliver legal and compliance
services overlap.

THE AUDITING FUNCTION

The primary objective of the auditing function is to audit a firm’s operations — that is, to verify that all of the
firm’s functions are conducting their affairs and activities in conformance with the operational procedures it has
established. In other words, that the rules established by the firm’s compliance and legal functions are being
followed. This is accomplished primarily through routine audit examinations.
Investment management firms generally require a number of different audit-related services throughout the year.
Depending on a firm’s specific requirements and circumstances, some of these services may be performed by
internal auditors — if the firm has an internal audit function — and some by external auditors.

EXTERNAL AUDITING
Some of a firm’s audit requirements must be performed by an external or third-party auditor. The two most
prominent instances are as follows:
1. Securities regulators require an investment management firm to provide audited financial statements as part
of its annual renewal application for its portfolio manager and exempt market dealer licences. Third-party
auditors must prepare these financial statements.
2. When acting in the capacity of a fund manager, an investment management firm should, according to
industry best practices, arrange for an annual audit of its investment funds. This particular audit requirement is
included in a fund’s prospectus and offering memorandum, as well as in limited partnership agreements, where
applicable. This audit is an integral part of a firm’s role as a fund manager and benefits investors or limited
partners, or both.

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INTERNAL AUDITING
As with any business, it is always good practice to conduct periodic audits of all aspects of an investment
management firm’s operations. The degree to which a firm needs internal auditors varies depending on its size and
complexity. Generally, small- to medium-sized firms do not have an internal audit function and use an external
auditor when required. Generally, a larger firm, or one that is a wholly owned subsidiary of a larger corporation,
either has a permanent internal audit staff or uses the internal audit resources of its parent company. The latter
is almost always the case for the investment management subsidiaries of mutual fund companies, banks and life
insurance companies.

THE ACCOUNTING FUNCTION

The primary objective of an investment management firm’s accounting function is to provide effective and efficient
accounting services. Firms have financial accounting needs related to their own internal operations and to the
funds they manage. Depending on the size of a firm and the number and complexity of the funds it manages, it will
provide accounting services through permanent internal accounting or third-party accounting service providers, or a
combination of the two.
The primary roles and responsibilities of a firm’s accounting function are as follows:
• Financial accounting services: These relate to the investment management firm’s direct ownership and
operations. In this case, the accounting function provides information about the firm’s financial affairs and
condition for the benefit of its owners, creditors and regulators.
• Fund accounting: In most investment management firms, the majority of the accounting function’s efforts
and resources are directed towards fund accounting, which is the proper accounting of a fund’s asset values.
The firm, for both portfolio manager and exempt market dealer registrations, is responsible for maintaining
the financial records for each of the funds it manages. Fund accounting must incorporate and report on the
following information for each fund:
Fund contributions and withdrawals
Security holdings and market value
Security transactions
Income earned (dividends and interest received)
Fund expense accruals, including charges from third-party service providers for which the fund is responsible,
such as audit fees, legal fees, custodial fees and investment management fees

It is imperative that fund accounting be both accurate and timely. Any shortcomings can have consequences,
some of them severe, for a firm and its reputation. Fund accounting reports have numerous users, including
a fund’s current investors, securities regulators and income tax agencies. Any errors in these reports can, and
often do, involve embarrassing fund accounting restatements that must be communicated to all of their users.
It is also important to note that any errors in fund accounting generally result in the incorrect calculation of a
fund’s net asset value (NAV), which is essentially the market value of its units or shares on a particular date.
Mutual fund NAVs must be calculated on a daily basis, since investors are permitted by securities regulations to
purchase or redeem units or shares from their funds on a daily basis.
The calculation frequency for NAVs of non-mutual fund investment products is stipulated in their offering
documents. In most cases, these products allow weekly, monthly or quarterly redemptions, so the NAV must
be prepared for the dates on which investor contributions or withdrawals are permitted. For a firm, a fund’s
incorrectly calculated and stated NAV can have two primary undesirable consequences:
1. The fund’s periodic rate of return figures will be incorrect since they are calculated on the basis of
determining the percentage change between the fund’s NAVs at the beginning and end dates, respectively,
for the time period. If there is an incorrect rate of return calculation, the firm must contact all affected

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parties as soon as possible with the corrected figures. This can be embarrassing and affect the firm’s image
with current investors and distributors. Depending on the product, it could even entail contacting the press
and firms that gather performance data.
2.The firm will also need to contact those investors who made contributions or withdrawals based on the
incorrectly stated NAVs. This can be a serious matter, since it means these types of transactions occurred at
incorrect values. The investor’s unit holdings figure and holdings value are incorrect and must be restated,
meaning that the number of units (or shares) the investor owns in the fund will need to be adjusted
downward to reflect the original error in its stated NAV.

• Unitholder record-keeping: This calculates and records the proportionate share or portion of a pooled fund that
is owned by each individual investor at any point in time. This percentage ownership is usually expressed in
terms of the number of a fund’s shares or units that each individual investor owns. This is somewhat in contrast
to fund accounting, where the purpose is to account for the entire fund and its total value without considering
who actually owns the fund. As such, fund accounting measures a total fund’s value, whereas unitholder record-
keeping determines the portion of a fund each investor owns.
Numerous third-party firms have expertise and specialize in providing unitholder record-keeping, which is
understandably a very important aspect of investment fund management. Some investment management firms
will perform unitholder accounting with internal accounting staff, while others will hire a third-party service
provider to fulfill these services on their behalf.

THE MIDDLE OFFICE’S KEY OPERATIONAL INTERFACES AND

INFORMATION FLOW
THE COMPLIANCE FUNCTION
The compliance department’s primary operational interfaces are within the front office’s portfolio management,
sales and marketing, and client service functions. This interaction is necessary, since the majority of an investment
management firm’s compliance requirements focus on matters that relate to the management of clients’ funds, as
well as to the information that is communicated to both current and potential investors.
However, the real function of a firm’s compliance department is to act as the go-between with securities regulators
in each province. The compliance department is a conduit through which information from a firm travels to the
regulators, and vice versa.

THE LEGAL FUNCTION

The legal function provides support to virtually all aspects of an investment management firm. Interaction tends to
be highest when a firm is making operational changes, such as launching new products, moving into new markets
and regulatory jurisdictions, and entering into new distribution arrangements.

THE AUDITING FUNCTION

Although the auditing function’s information needs tend to be extensive, it is not normally involved in the day-to-
day flow of information throughout a firm. However, when needed, the auditing function interacts with all aspects
of a firm over the course of an audit cycle. An audit cycle is the period of time during which the audit staff examines
every aspect of a firm. This period of time would typically be one year for areas such as portfolio management,
sales and marketing, and accounting. For other areas of the firm, where the overall business and related risks are
considered to be low, the audit cycle could be as long as two years.

THE ACCOUNTING FUNCTION

With regard to a firm’s own operations, the accounting function has standard interfaces that exist in most firms,
such as accounts payable, accounts receivable and payroll.

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However, with regard to fund accounting, there are a number of major interfaces to and from which information
flows, both internally and externally, but these vary somewhat based on the type of fund information that is being
accounted for. In all cases, the accounting staff obtain data from at least two different sources to aid in confirmation.

Fund contributions and Sales and marketing or client service staff provide fund accounting and unitholder
withdrawals record-keeping staff with information regarding fund contributions from new and
existing investors, as well as investors who are making withdrawals. This information is
usually provided in both the dollar amount and in the number of the fund’s shares or
units that are being purchased or sold. It is then reconciled with information from the
fund’s custodian regarding the amount of money that was received from or paid out to
investors.

Security holdings and Security holdings information is obtained internally from a firm’s back office. This
market values, and information includes the security’s name and its description, the number of units bought
security transactions or sold, and the price paid or received, both on a per share or unit basis, and as the
entire security transaction’s value. This data is then reconciled with similar information
provided by the fund’s custodian. This comparison confirms the fund’s security holdings.
Market values for a fund’s individual security holdings are also obtained from two
independent sources. Security pricing data are provided by the fund’s custodian. Daily
closing pricing information is obtained directly from various exchanges or third-party
security pricing data suppliers, such as Bloomberg or Thomson Reuters. A firm’s fund
accounting staff compares the security pricing data and investigates when there is a
difference between pricing data that is greater than a pre-determined allowable amount.
Sometimes, a third independent security pricing source is consulted and an average of all
three prices is used in the final calculation of a security’s market value. (See Chapter 12
for more information on this topic.)

Income earned Fund valuation includes all forms of income earned by a fund. The two major sources of
(dividends and interest income earned are dividends received on common stock and preferred stock holdings,
received) and interest received on money market securities and fixed income investments. The
fund accounting staff receives data from a fund’s custodian regarding the amount of
all dividends and interest paid to a fund. This information is compared to the amount
of interest income accrued and dividend income expected by the fund accounting
staff. Interest income is automatically accrued by a firm’s accounting software, while
dividends are calculated based on data feeds from third-party service providers who
monitor and report on particulars regarding declared dividends, such as the amount and
payment date.

Fund expense accrual This aspect of fund accounting involves the accrual of various expenses related to a
fund’s overall management. As noted earlier, it includes third-party expenses, such as
fund audit fees, custodial fees, legal fees and investment management fees. All of these
expenses are paid by the fund to third-party service providers.

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MIDDLE OFFICE BEST PRACTICES

THE COMPLIANCE FUNCTION
Key best practices related to the compliance function are as follows:

Leadership The head of the compliance function must be the individual designated with the
securities regulators as the firm’s chief compliance officer. In turn, the chief compliance
officer should report directly to the person designated with the securities regulators as
the firm’s ultimate designated person (the firm’s president).

Communications with All compliance-related matters and communications with regulators should be
regulators channelled through the compliance function to maintain clear and consistent
communication between the firm and its regulators.

Prior approval of new When a firm is launching new products or services, the compliance department’s prior
investment products approval is required. This ensures the new product or service complies with regulations,
as well as with registrations the firm holds.

Prior approval when The compliance function should be part of the review and due diligence process when a
contracting new firm enters into a new distribution contract.
distributors

Straight-through The compliance department should be included in the process of analyzing a new STP
processing (STP) system to ensure that their needs, particularly with regard to monitoring portfolio
system management, are managed effectively.

Personal trading A firm must have a clear and concise policy and process regarding the administration of
pre-approval personal trading.

THE LEGAL FUNCTION

Key best practices related to the legal function are as follows:

Reporting relationship The head of the legal function should report directly to a firm’s president.

New product creation When a firm is contemplating the decision to offer new products or services, legal
counsel should be involved early in the process. This helps ensure that the product
structure is appropriate from a legal and regulatory standpoint.

New contract Processes should be in place across an entire firm to ensure that prior approval is
approval process obtained from legal staff for all new contracts.

THE AUDITING FUNCTION

Key best practices related to the auditing function are as follows:

Reporting relationship The head of the audit function normally reports directly to a firm’s president. However,
it is considered good practice for the head of the audit function to also have a parallel
reporting relationship to a firm’s management committee or board of directors, or both
— at least on a quarterly basis. This report should include information about the results
of the most recently performed audits and the status of the remediation of deficiencies
identified in previous audits.

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Audit privileges with A firm should have a policy in place that attempts to negotiate audit privileges with
third-party contactors third-party contractors — that is, the ability to audit its contractors. It is unheard of for
a contractor to consent to full audit privileges. However, many service providers to the
investment management industry do have independent annual audits conducted on
those particular aspects of their operations that are considered to be of most importance
to their clients.

THE ACCOUNTING FUNCTION

Key best practices related to the accounting function are as follows:

Reporting relationship As with other middle office functions, the accounting function should report to a firm’s
president. From an organizational standpoint, the fund accounting function must be
separate and independent from both a firm’s front and back offices.

Straight-through In the case of the fund accounting function, an STP system is critical to ensuring efficient
processing (STP) fund accounting operations. As discussed earlier, the fund accounting function interfaces
system with numerous internal and external sources of fund information data. As such, having
all of this data online in one database can lead to efficient fund accounting with minimal
errors.

THE BACK OFFICE

The primary objective of a firm’s back office is to settle security transactions in an efficient and effective manner. This
activity is otherwise known as the trade settlement function. Security trades are not complete until they are settled.
The trade settlement function ensures that all of a firm’s security transactions, both purchases and sales, are settled
in the correct amounts and accounts or portfolios/funds, and at the agreed upon time. The number of security
transactions a firm generates depends on a number of factors, including:
• The number of separate mandates or funds managed
• The type of mandate, such as equity, fixed income or money market
• The geographic aspects, such as domestic or global
• The firm’s trading philosophy

Although the four primary factors listed above affect a particular investment management firm’s annual security
trading volume, its trading philosophy is likely the most important determining factor. Trading philosophy refers to
the role that active security trading plays in executing a particular fund’s investment management strategy.
All active portfolio management strategies, as compared to passive investment strategies, such as index funds,
involve some degree of security trading in their execution. However, the amount of trading is unique to each
individual portfolio manager. Even with identical investment mandates, two portfolio managers could have very
different attitudes regarding the amount of value they can add to a fund by trading securities on a more frequent
basis.
The degree or amount of active management, specifically trading activity, is usually measured and reported in terms
of Portfolio turnover, which is calculated using the following equation:
Annual market value of security trades (6.1)
Portfolio turnover =
Market value of the portfolio

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 CHAPTER 6 | THE MIDDLE AND BACK OFFICES 6 • 15

This ratio can be as low as 0.25 for a fairly inactive investment strategy, to as high as 2 to 4 for a very actively
managed fund. Most funds have annual portfolio turnover ratios in the range of 0.75 to 1.25.
Clearly, the level of activity of a firm’s back office or trade settlement function can vary substantially from firm to
firm. However, in an investment management firm, it is fairly typical for the trade settlement function to have the
largest staff compared to its other functions.

THE BACK OFFICE’S KEY OPERATIONAL INTERFACES AND INFORMATION

FLOW
The back office has five main operational interfaces three internal, including portfolio managers, trading staff and
the fund accounting function, and two external.

Internal interfaces The firm’s trade settlement area receives electronic trade tickets or confirmations, which
provide information about confirmed trades with investment dealers, from its trading
staff. These tickets, which are normally received electronically if the firm uses an STP
system, inform the trade settlement staff that a security trade is pending settlement.
The internal trade confirmation provides all of the details about the particular security
trade, including the number of shares, price per share, commission, investment dealer’s
name and ID number, fund to settle the trade in, and so on. After the trade has been
settled successfully, which is generally the same day for money market trades, or two
clearing days for bond and equity trades, the trade settlement area will inform the fund
accounting staff. This information is also conveyed electronically through a firm’s STP
system.

External interfaces The back office also receives an electronic trade ticket from the investment dealer
with which the firm has executed the trade. The details on this ticket are automatically
matched to the details provided on the ticket the firm’s trading staff received. Any
variance in the ticket information will be immediately discussed and resolved with
the internal trader who generated it. The trade settlement staff will also receive a
confirmation from the fund’s custodian once the trade has settled at the custodian’s
facilities. This step marks the end of the trade settlement process.

BACK OFFICE BEST PRACTICES

Key best practices of a firm’s back office are as follows:

Reporting structure Trade settlement staff should report to a firm’s president and be independent of both its
front office and fund accounting functions.

Straight-through It is very important for a firm to use an STP system. Automation can ensure that security
processing (STP) system trades are settled correctly and on time.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe the organizational structure of a modern investment management firm’s typical middle office.
A modern institutional investment management firm’s typical middle office has the following four main
functions: compliance, legal, audit and accounting.

2. Outline the main roles and responsibilities of an investment management firm’s compliance function.
The roles and responsibilities of a firm’s compliance function focus on three primary areas:
« Licensing and regulatory reporting: Ensures that both a firm and its employees have the required licences
and registrations to offer their investment products and services. Provincial securities regulators also
require registrant firms to file various interim reports on a monthly basis.
« Sales and marketing, and client service: Ensures that all of a firm’s written and verbal communications, as
well as its dealings with current and potential investors, conforms to appropriate regulations.
« Portfolio management: Ensures that each of a firm’s investment mandates has its own unique set of
written investment guidelines and restrictions, and that they form part of the investment management
agreement executed for each portfolio.

3. Describe the straight-through processing (STP) system and explain why it is important for investment
management firms to use this type of portfolio data management system.
An STP system is a single information database that is designed around all of the necessary steps required to
properly execute, record and settle a security trade.
An STP system operates on a real-time basis.
An STP system is designed to avoid human errors associated with securities trading, settlement and record-
keeping activities.

4. Outline the main roles and responsibilities of an investment management firm’s legal function.
The primary objective of an investment management firm’s legal function is to help ensure the firm has
structured its business affairs properly from a legal perspective — that is, the firm cannot get into a situation
where it could be held financially liable to another party.

5. Explain why it is important for an investment management firm’s operations to be audited.

To verify that all of the firm’s functions are conducting their affairs and activities in conformance with the
operational procedures it has established.

6. Explain the difference between fund accounting and unitholder record-keeping.

Fund accounting is the proper accounting of a fund’s asset values.
Unitholder record-keeping calculates and records the proportionate share or portion of a pooled fund that is
owned by each individual investor at any point in time.

7. Explain a fund’s net asset value (NAV) and describe what the consequences are for its manager if the fund has
an incorrectly calculated and stated NAV.
The NAV is essentially the market value of a fund’s units or shares on a particular date.
For a firm, a fund’s incorrectly calculated and stated NAV for a fund can have two primary undesirable
consequences:
« If there is an incorrect rate of return calculation, the firm must contact all affected parties as soon as
possible with the corrected figures.

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 CHAPTER 6 | THE MIDDLE AND BACK OFFICES 6 • 17

« The firm will also need to contact those investors who actually made contributions or withdrawals based
on the incorrectly stated NAVs.

8. Describe the primary roles and responsibilities of an investment management firm’s back office.
The primary objective of a firm’s back office is to settle security transactions in an efficient and effective
manner.

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 Managing Equity Portfolios 7

CONTENT AREAS

Bottom-Up and Top-Down Approaches

Portfolio Management Styles

The Use of Derivatives in Equity Portfolio Management

Tax Considerations

The Use of Exchange-Traded Funds (ETFs) in Equity Portfolio Management

LEARNING OBJECTIVES

1 | Describe the bottom-up and top-down approaches to equity portfolio management.

2 | Differentiate between the value-oriented and growth-oriented approaches to investing.

3 | Describe the passive style of equity portfolio management and discuss the three techniques normally
used to construct an index fund.

4 | Explain how to use the risk budgeting process to build a portfolio.

5 | Describe the active style of equity portfolio management, including enhanced active equity
investing, long–short investing and portable alpha strategies.

6 | Explain how derivatives can be used to reduce an equity portfolio’s systematic risk.

7 | Aside from hedging, demonstrate the ways in which derivatives can be used in equity portfolio
management.

8 | Discuss the taxation considerations of various equity portfolio management styles.

9 | Describe exchange-traded funds (ETFs) and discuss the ways in which they can be used in equity
portfolio management.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

active portfolio management index tracking

alpha management styles

beta passive portfolio management

bottom-up approach portable alpha

closet indexing prime brokerage structures

enhanced active equity investing replicating an index

enhanced indexing risk budgeting

fundamental indexing sector rotation

growth-oriented approach top-down approach

hedged portfolio tracking error

index funds value-oriented approach

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7•3

INTRODUCTION
It is well known that asset diversification within an investment portfolio reduces risk for a given level of expected
return if the portfolio’s assets have less than perfectly correlated expected returns. In a well-diversified portfolio, the
volatility of one security can offset the volatility of another.
Portfolio construction has been based on this concept ever since 1952, when Harry M. Markowitz released his
ground-breaking work entitled “Portfolio Section” in the Journal of Finance.1 In theory, the risk-reducing benefits
of diversification can be derived from as few as two randomly selected assets. In addition, fundamental statistical
concepts, such as portfolio expected return and portfolio risk, apply equally to small and large portfolios. With
large portfolios, although the concepts do not change as more and more assets are considered, the number of
computations grows quickly. In the real world, portfolios rarely have only two or three assets. Generally, portfolio
managers combine many assets in order to eliminate diversifiable risk as they build a preferred structure of risk
and expected return within a portfolio. They may design a portfolio to emphasize assets from a particular sector
or industry, or to meet a certain maximum or minimum capitalization size, or to achieve an international mix of
securities.
As hedge funds become more mainstream, the line between portfolio construction techniques employed by
conventional mutual funds and those employed by hedge funds has been blurred. To increase returns, institutional
investors are increasingly turning to the strategies hedge fund managers employ.
This chapter deals exclusively with the design and management of equity portfolios, both conventional and non-
conventional ones. For the most part, the content of this chapter has its foundation in modern portfolio theory
(MPT), which in turn is built on the assumptions of capital market efficiency. In practical terms, MPT proposes that
a portfolio manager construct a portfolio through diversification while they are establishing a clear quantitative
picture of the expectations for its performance. Once the portfolio is in place, the manager must regularly maintain
and rebalance the portfolio in order to remain true to the original design objectives, assuming, of course, the
objectives remain relevant.

BOTTOM-UP AND TOP-DOWN APPROACHES

The systematic method that a portfolio manager uses to select individual securities and build a portfolio may
be categorized as either a top-down or bottom-up approach. The type of approach used depends on a portfolio
manager’s assumptions about market efficiency, as well as their analytical strengths compared with other peers in
the financial marketplace. A portfolio manager’s approach naturally leads them to develop a management “style”.

THE BOTTOM-UP APPROACH

The bottom-up approach to investing can take the form of either a value-oriented or growth-oriented approach.
For both of these approaches, the portfolio manager begins by seeking out individual securities to include in a
portfolio.

VALUE-ORIENTED, BOTTOM-UP APPROACH

A portfolio manager who uses the value-oriented approach looks for undervalued securities with little focus on
overall economic and market conditions. The manager attempts to find stocks with a low price-earnings ratio that
are trading at a discount to book value. A value-oriented manager is usually prepared to wait many years in order to
recognize a stock’s full value.

1
Harry M. Markowitz, “Portfolio Selection,” The Journal of Finance 7, No. 1 (March 1952): 77–91.

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7•4 PORTFOLIO MANAGEMENT TECHNIQUES

Warren Buffett, the famous U.S. investor of Berkshire Hathaway, is an example — albeit an extraordinary one — of
a value-oriented, bottom-up manager. Buffett’s approach to portfolio management is based on security selection.
He is known to put little faith in portfolio management in the modern sense; rather, after thorough investigation,
he buys a selective few investments and then holds them for a long time, seemingly indefinitely. Buffett does not
believe the markets are efficient, and his phenomenal investment performance over the past 45 years is an anomaly
among portfolio managers, no matter what their approach.
During his post-graduate studies at Colombia University, Buffett was profoundly influenced by two of his
professors — Benjamin Graham and David Dodd — who both wrote landmark works in the field of value-oriented
investing.2, 3 In his early years of investing, Buffett followed Graham’s approach by seeking out highly undervalued
securities. Graham’s favourite technique was to find stocks that traded at one-third less than their net working
capital. However, this strategy became more difficult to implement once the market became efficient to the
strategy. Over time, Buffett’s strategies have evolved, but they remain based on the bottom-up approach to
portfolio building.4
The value-oriented, bottom-up approach to building a portfolio leads to a somewhat passive management style of
portfolio management, in the sense that once the securities have been selected, the manager remains invested in
them for a long period of time. Time is needed for the investment’s full potential to be realized and for the market
to also recognize this potential. Value-oriented, bottom-up investing presumes that the market is not completely
efficient at pricing securities. The manager must have superior skills to identify securities that are undervalued or
have unrealized potential.

EXAMPLE
Two Bottom-up Investment Strategies
Strategy #1: Benjamin Graham’s Asset Value Strategy

In his book Security Analysis, Benjamin Graham defines investment as follows: “An investment operation is one
which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting
these requirements are speculative.”
Graham considered thorough analysis to be the careful study of available facts with the attempt to draw
conclusions based on established principles and sound logic. He considered “satisfactory” return to be a
subjective measure, and he strongly recommended diversifying investments to reduce risk. The net current
asset value approach is the name Graham applied to the strategy he reportedly first developed and tested in the
1930s.*
A company’s current assets include cash, inventories, accounts receivable and other assets that are expected to
generate cash within one year or one operating cycle. Graham’s approach starts by adding up the current assets
and subtracting total liabilities. The difference is the company’s net current asset value. In order to determine the
net current asset value per share, one must divide the net current asset value by the number of shares outstanding.
Graham’s strategy calls for selecting stocks that sell for 66.67% or less of their net current asset value. For
example, according to Graham’s approach, if a stock’s net current asset value is $10 per share, an investor should
not pay more than $6.67 for it.
Here is an example of Graham’s method for selecting stocks:
1. Assume a stock’s current price is $12 and the number of shares outstanding is 4 million.
2. The company’s total current assets and total liabilities are $160 million and $80 million, respectively.

2
Benjamin Graham, The Intelligent Investor: The Classic Text on Value Investing (Toronto: Harper Business, 2005). First published in 1949.
3
Benjamin Graham and David Dodd, Security Analysis (New York: McGraw-Hill, 2004). First published by Whittlesey House, New York, in 1934.
4
Roger Lowenstein, Buffett: The Making of an American Capitalist (New York: Doubleday, 1995).

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7•5

EXAMPLE
Two Bottom-up Investment Strategies – cont'd
3. Subtract the total liabilities from the current assets ($160 million – $80 million) to get a net current asset
value of $80 million.
4. Divide $80 million by the number of shares outstanding (4 million), which gives a net current asset value of
$20 per share.
5. Graham’s strategy says the stock price cannot exceed 66.67% of the net current asset value — in this case,
$13.33 per share ($20 x 0.6667). At $12.00, the stock’s current price meets this criteria.

Strategy #2: Warren Buffett

As clients become more familiar with investment strategies, it is a portfolio manager’s responsibility to not only
understand the theories that their clients may be reading about, but also the strengths and weaknesses of these
theories as they pertain to their clients’ expectations and investment profiles. As mentioned earlier, Warren
Buffett is one of the most influential investors of our time, and a fundamental understanding of his investment
strategy is essential, whether one subscribes to the analytical approach or not.
Buffett’s strategy is straightforward, as follows:
1. Turn off the stock market.
2. Do not worry about the economy.
3. Buy a business, not a stock.
4. Manage a portfolio of businesses.

His 10 basic analytical tenets are the following:

1. Over the long haul, equities outperform other investments.
2. The soundness and potential of an individual underlying security is the true measure of value.
3. The ability to analyze a business’s fundamental soundness lessens the need to broadly diversify one’s
holdings, which tends to lower returns relative to a concentrated portfolio of well-performing stocks.
4. Investors are not always rational and may not process information correctly.
5. Risk is not based on price but on economic value. In other words, the spread between value and price is the
most important determinant of whether a security meets the selection criteria.
6. Focus on 10 to 12 securities of the highest value from high-potential companies, and stay with them for
the long term, unless there are overwhelming reasons for change. These would include a major change in a
company’s senior management that weakens its ability to compete successfully in the longer term.
7. The most important measuring stick is a company’s intrinsic value and its weighted average cost of capital
(WACC). The market may not recognize it right away in terms of price, which presents an opportunity for
the portfolio manager to acquire more shares at a bargain price until the market catches up.
8. Minimize the impact of transaction costs.
9. Measure returns on an after-tax basis.
10. Use the power of compounding returns to maximum advantage.
* Graham and Dodd, Security Analysis: 54.

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7•6 PORTFOLIO MANAGEMENT TECHNIQUES

GROWTH-ORIENTED, BOTTOM-UP APPROACH

As a bottom-up approach, the growth-oriented approach focuses on individual stocks. However, where the value-
oriented approach looks for undervalued securities, the growth-oriented approach focuses on earnings. Specifically,
a growth-oriented portfolio manager chooses stocks with superior earnings growth rates relative to the market
in general. Another key difference between the value-oriented and growth-oriented approaches is that a growth-
oriented manager has higher turnover in their portfolio.

THE TOP-DOWN APPROACH

The top-down approach begins with a macro- and microeconomic analysis of trends and market forecasts in
the global, North American and Canadian economies. A portfolio manager selects the sectors they expect will
outperform other sectors within the expected economic outlook. To maximize liquidity, the manager buys large-
capitalization stocks within each sector.
The top-down approach is based on the premise that the performance of economic sectors ebbs and flows in
response to changes in the economic cycle, and that the portfolio manager has the skills to pick the sectors that are
most likely to experience superior growth. Such a manager is likely to display an active management style and could
be characterized as a sector rotator or market timer.

PORTFOLIO MANAGEMENT STYLES

Equity portfolio managers pursue a variety of investment strategies that are known as management styles. Today,
managers tend to be specialists within a particular management style. A manager hopes to take advantage of
superior skills in practicing their management style. The client, whether a plan sponsor or a fund investor, should
be prepared to pay the management fees in return for those specialized skills. Major fund sponsors may employ a
number of portfolio managers with different management styles in order to diversify a fund. Generally, portfolio
management styles fall into two categories: active and passive. Fund managers may also be differentiated according
to the market capitalization of the stocks they tend to buy and by their growth or value orientation. The section that
follows describes passive and active management styles and portfolio construction techniques. These styles will be
compared at the end of the section.

PASSIVE MANAGEMENT STYLES

Passive portfolio management is consistent with the view that securities markets are efficient — that is, securities
prices always reflect all relevant information concerning expected return and risk. By practicing the passive
management style, a portfolio manager admits their inability to consistently identify stocks as underpriced or
overpriced. Instead, they concentrate on portfolio construction that meets particular needs, and on maintaining
their preferred structure through periodic rebalancing.
Often, the strategic objective of passive portfolio management is to track the performance of a relevant target
benchmark, which is typically an index, such as the S&P/TSX Composite Index or the S&P 500 Index. These
are referred to as index funds. While index funds are passive, passive portfolio management is not necessarily
restricted to them. A portfolio can have virtually any expected risk-return profile. If they wish, a portfolio manager
may augment a portfolio with different characteristics for yield, sector, capitalization and so on, and then passively
maintain that structure.

CONSTRUCTING AN INDEX FUND

Replication, tracking and index matching are terms related to passive portfolio management. The rationale behind
constructing an index fund is that a well-diversified index represents an average portfolio, and a portfolio manager

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can do no better than the average over the long run. In terms of portfolio theory, an index fund only accepts
systematic risk. There are three approaches to constructing an index fund:
1. Replicating an index
2. Tracking an index
3. Fundamental indexing

REPLICATING
When replicating an index, a manager selects an appropriate index to replicate in a fund, then holds each stock
within the fund’s portfolio in exact proportion to its weighting within the index.

EXAMPLE
If the target index is the S&P/TSX Composite Index and the Bank of Montreal represents 0.75% of this index, the
replicating index fund must hold 0.75% of its assets in Bank of Montreal stock.

A portfolio containing all of the stocks in the S&P/TSX Composite Index is unwieldy. The majority of companies
within the S&P/TSX Composite Index have less than a 0.50% weight in the index. For practical purposes, a portfolio
replicating the S&P/TSX Composite Index is likely to be over-diversified, which occurs when the next stock added to
it contributes little or no reduction to the portfolio’s unsystematic risk.

TRACKING
An alternative to replicating is index tracking. With this approach, a portfolio manager constructs a subset of the
benchmark that faithfully mimics an index. In other words, the resulting portfolio is highly correlated with an index
without necessarily holding all of its stocks. Sampling and mathematical models are two different methods that
managers use in index tracking.
For example, with the sampling model, a portfolio manager might construct an index consisting of most of the
larger-capitalization stocks in the underlying index, plus only a sample of its smaller-capitalization stocks. The idea
is to capture the majority of the correlation using the large-capitalization stocks. This structure gives the fund a
portfolio that mimics the underlying index without being as large as the index. A mathematical model may involve
the use of historical data in order to construct a fund that does not hold all of the underlying index’s securities but
nevertheless faithfully mimics it.
The efficiency of index tracking must be weighed against the inaccuracy of tracking versus the index itself. The loss
of accuracy is referred to as tracking error, which is the standard deviation of the return difference between the
portfolio and the index. If an index fund is constructed properly, the tracking error tends to be small. For this reason,
full replication tends to be unnecessarily costly. Of the three methods of constructing an index, the industry’s
preferred method is tracking.

FUNDAMENTAL INDEXING
Market capitalization is the primary method for weighting a security in a conventional indexed portfolio. This
approach has the advantages of diversification, low turnover, broad market participation and modest expenses.
However, capitalization-weighted indexes suffer a structural flaw that imposes a drag on returns.
In a semi-efficient market, most stocks will be priced above or below their intrinsic value. Those priced above their
intrinsic value will have a capitalization higher than merited and an erroneously high index weighting. These stocks
will make up the majority of an indexed portfolio and will suffer a performance drag as prices migrate towards their
true value. Those priced below their intrinsic value will have a lower than merited capitalization and an erroneously
low index weighting. These stocks will give the index a performance boost, but one that is too small to offset
the losses from overpriced stocks, because the former constitute less of the portfolio. In this way, capitalization-
weighted indexes systematically overweight overpriced securities and underweight underpriced ones. For example,
consider the top 10 stocks in a capitalization-weighted portfolio. Some stocks are in the top 10 because they are

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7•8 PORTFOLIO MANAGEMENT TECHNIQUES

very large companies whose true value is accurately reflected. However, others will get there as a result of being
overvalued. For passive index investors, more of their portfolio will be invested in overvalued stocks and less in
undervalued ones, which is the opposite of what common sense suggests.
Fundamental indexing was developed to solve the problem of structural return drag.5 According to the
methodology, each stock’s index weighting is determined by four fundamental measures — not by its expected
future size, as reflected in market capitalization — thus diluting weighting errors and erasing the link between
portfolio weight and over- or undervaluation. The fundamental metrics were chosen to reflect a company’s business
activity as accurately as possible, as follows:
• Trailing five-year cash flow (cash flow)
• Trailing five-year sales (sales)
• Trailing five-year gross dividends (dividends)
• Book value (book)

The top 1,000 stocks are selected in each metric and ranked proportionately in that category. The index is created
by equally weighting the four categories.

EXAMPLE
Imperial Oil (IMO) would receive a 3% weight in the sales index if its sales represented 3% of the combined
trailing five-year total sales of the top 1,000 sales companies.
If IMO represents 3% of the economy by sales and cash flow, 2% by book value and 4% by dividends, we average
the four measures to determine that it represents about 3% of the economy. IMO is given a weight of 3% in the
fundamental index, regardless of share price, valuation multiples or market capitalization.

Multiple metrics were used to smooth out some of the drawbacks of using a single measure:

Dividend-based metric A dividend-weighted index has the correlation of size to excess returns, and has the
largest tracking error relative to capitalization-weighted indexes, which leads to the
least consistent value-added of the metrics. On average, it is the only measure that has
underperformed in bull markets. However, the most glaring drawback of dividend-based
indexes is that they exclude more than half of the market’s publicly traded companies,
including most growth stocks and essentially all emerging growth companies. For this
very reason, a special provision is made for zero yield companies — those companies
that have paid no dividends in the past five years — so that they are weighted equally
according to the other three metrics.

Sales metric This metric is not well defined in some of the service industries, such as financial services
and trading companies.

Cash flow metric This metric may lead to over- or underexposure to highly cyclical companies.

Book value metric This metric may lead to over- or underexposure to companies with aggressive or
conservative accounting practices.

Clearly, for any fundamental index, using a single metric can lead to a skewed sample of companies. A blend of
multiple measures, along with the use of multi-year smoothing, can mitigate exposure to any of these problems and
sharply reduce turnover.

5
Robert Arnott, Jason Hsu, and Philip Moore, “Fundamental Indexation,” Financial Analysts Journal 61, No. 2 (March/April 2005): 83–99.

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7•9

EXAMPLE
Comparing Fundamental Versus Capitalization Weighting
Robert Arnott compared the return performance of the S&P 500 Index, the most widely used market
capitalization index in the U.S., to the performance of a fundamental index constructed from the largest 1,000
U.S. companies in each metric.* Over a 44-year evaluation period from 1962 to 2005, the fundamental index
produced excess returns of 2.1%, with slightly less volatility than the S&P 500 Index. Under different market
environments, on average the fundamental index outperforms marginally in bull markets, while producing
significant excess returns in bear markets.
The fundamentally weighted index’s turnover is extremely low relative to an actively managed portfolio, and only
slightly above that of an average capitalization-weighted index. The historical turnover is just over 10% versus
approximately 6% for an annually rebalanced portfolio of the 1,000 largest-capitalization stocks. Furthermore,
the fundamental index’s turnover tends to be in larger-capitalization issues, with smaller transaction costs, that
have seen changes in their fundamentals. Meanwhile, capitalization-weighted portfolios tend to experience most
of their turnover in smaller companies — meaning, higher transaction costs — that fall off, or step up onto, the
capitalization-weighted list, which is typically near the bottom of it.
More importantly, during periods of rapid price increases, the fundamental index did not become grossly
concentrated within one sector, as did conventional capitalization-weighted indexes; for example, during the
technology bubble of 1999. The S&P 500 Index’s technology sector weighting ballooned from 8% in 1995 to well
over 20% in 1999. In the fundamental index, the technology sector’s weighting rose no higher than 10% in 1999
from 5% in 1995.** Under fundamental indexing methodology, companies do not receive additional allocations
within the index, unless they grow their cash flows, dividends, sales and book value faster than the rest of the
economy.

* Robert Arnott and John West, “Fundamental Indexes: Current and Future Applications,” Institutional Investor’s Fifth Annual
Exchange-Traded Funds Review (Fall 2006): 111–21.
** Jason Hsu and Carmen Campollo, “New Frontiers in Index Investing,” Journal of Indexes (January/February 2006): 32–58.

CLOSET INDEXING
Closet indexing refers to the tendency of active managers to build a portfolio that is close enough to a
performance benchmark, so that the portfolio neither underperforms nor outperforms the benchmark by much.
The purpose of this strategy is to help underachieving active portfolio managers avoid getting fired. It is a strategy
based on the management concept of “satisficing” — that is, a manager is happy to perform reasonably well and
their personal welfare is the motivating force. Closet indexing implicitly ignores the formal investment objectives
established for a portfolio.
The active portfolio manager is expected to add value to a portfolio, and clients pay a higher active management
fee in return for this value-added. Closet indexing is a practice that short changes the interests of a fund beneficiary
or holder in deference of a fund manager’s interests. The clients or beneficiaries of such a fund find themselves
paying active management fees for index performance, which is clearly unacceptable.
This practice has been noted by OMERS, which has taken steps to lock in the management styles of both its internal
and external portfolio managers in order to avoid the practice of closet indexing. With the rapid growth of the
number of index funds in the Canadian marketplace in recent years, closet indexers will likely be squeezed out of the
industry by funds with defined management styles.6 If a fund sponsor is faced with the choice of an index fund with
low management fees and an actively managed fund that has shown the same basic performance as the index fund
because it has been closet-indexed, the sponsor will opt for the latter fund because of its lower management fees.

6
Andrew Willis, “OMERS Shuts Out Closet Indexing,” Globe and Mail, March 27, 1996.

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7 • 10 PORTFOLIO MANAGEMENT TECHNIQUES

ENHANCED INDEXING
Risk budgeting7 is a process that limits the deviations of a portfolio’s return from a benchmark. It is the most
common technique used to create an enhanced index portfolio. Enhanced indexing results in portfolios that are
designed to provide index-like performance with some excess return net of costs. Active risk is introduced by slightly
overweighting and underweighting securities. This level of active risk is closely monitored.
An acceptable tracking error is predetermined and alpha, which is the return from unsystematic risk, is maximized
within those limits. A typical enhanced index portfolio’s active risk is not allowed to exceed 2% per annum.
On a spectrum of systematic risk exposure, risk budgeting lies between passive indexing and active investment
management.
There are four steps in the risk budgeting process. The first step is to pick a benchmark portfolio, which should be
created cheaply and maintained passively. The benchmark’s expected risks and returns should match the investor’s
needs and preferences. If no better opportunity arises, the investor should view a passive investment in the
benchmark as a viable alternative.
The second step is to set the maximum acceptable portfolio tracking error. A tracking error indicates how closely the
portfolio is following the benchmark. A portfolio’s tracking error reveals the reliability of the portfolio’s alpha. If the
tracking error is high and the alpha is positive and low, the alpha is likely not to be repeated. As such, it is probably
a random fluctuation, not the result of superior investing, and there is a good chance the next period will carry a
negative return, which will wipe out any gains.
The ratio of alpha to tracking error can be monitored using the information ratio, as follows
Alpha (7.1)
Information ratio =
Tracking error

Given an expected alpha and a maximum tracking error, the information ratio can be used to ensure a portfolio is
producing enough excess return to justify the deviations from its benchmark.
The third step is to try and identify active management return opportunities. This means making — or trying to
make — superior tactical asset allocation decisions, as well as identifying superior securities from the benchmark or
superior investment managers.
The final step is to use the identified return opportunities to build a portfolio without exceeding the tracking error
limit. A portfolio could have a multitude of asset classes or a multitude of securities combinations that could fall
within the risk budget. However, only one will maximize the alpha and still remain within the tracking error limit.

Exhibit 7.1 | The Four Steps of the Risk Budgeting Process

1. Determine the portfolio’s appropriate benchmark.

2. Determine the portfolio’s maximum acceptable tracking error. This sets a maximum for how large of an
unexpected return “surprise” the portfolio could experience.
3. Identify the tactical asset allocation or specific return opportunities among securities.
4. Build a portfolio that deviates from the benchmark using the return opportunities identified in step three
(described above). The portfolio should maximize expected excess returns without exceeding the tracking error
limit determined in step two (also described above).

7
James Gilkeson and Stuart Michelson, “Risk Budgeting: Investment Cruise Control for Your Clients,” FPA Journal, November 2005.

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7 • 11

AN ILLUSTRATION: RISK BUDGETING AND ASSET ALLOCATION

Assume there is a portfolio composed of 55% stocks, 30% bonds and 15% cash, with a maximum risk budget of
1.00% per quarter. The expected return, risk (standard deviation of returns) and correlations for each asset class per
quarter are given in Table 7.1 below.

Table 7.1 | Expected Returns, Risk Percentages and Correlations a Sample Portfolio

Expected Correlation Correlation Correlation

Weight Return Risk (%) with Stocks with Bonds with Cash
Stocks 0.55 1.35% 4.50 +1.0 +0.6 0.0
Bonds 0.30 0.95% 0.90 +0.6 +1.0 0.0
Cash 0.15 0.75% 0.00 0.0 0.0 +1.0

If dw is defined as the change from the benchmark weight in each asset class, then the sum of all the asset class
deviations must be zero, since any increase in an asset class weight is at the cost of another asset class weight. For
the portfolio, this is determined from the following equation:
dw(cash) + dw(stocks) + dw(bonds) = 0 (7.2)

To illustrate, if the stock weight increases by 20%, the allocations to bonds and cash must together drop by 20%.
Therefore, the portfolio’s expected alpha can be expressed as follows:
E [ alpha] = E êé Rportfolio úù - E [ Rbenchmark ] = dw(cash) Rcash + dw(stocks)E [ Rstocks ] + dw(bonds)E [ Rbonds ] (7.3)
ë û
In a mean-variance framework, the expected tracking error can be expressed as follows:8
TE = SDportfolio-benchmark (7.4)
é dw 2 2 ù
ê (bonds) var(bonds) + dw (stocks) var(stocks) + ú
= square root ê ú
ê2dw dw SD SD corr ú
êë (stocks) (bonds) (bonds) (stocks) (stock, bond) úû

There is not a single solution to the tracking error equation that gives a maximum alpha while limiting the tracking
error to the budgeted amount. It depends on how the relationships play out between the expected returns, risks and
correlations. Furthermore, the formula grows more difficult as more asset classes (and correlations) are added. Still,
an investor can adjust the various benchmark allocations to find a good one.
This is done in Tables 7.2 and 7.3. In both tables, the columns correspond to changes in the cash allocation and the
rows to changes in the bond allocation. Each change in the cash and bond allocation implies a change in the stock
allocation. For instance, if the bond allocation decreases by 20% and the cash allocation increases by 10%, the
stock allocation must increase by 10% because the changes must add up to zero, as follows: (+10 – 20 + 10) = 0.
Shorting of stocks is not permitted.

8
Please note that “var” represents the variance. The variance is equal to the standard deviation squared, or conversely, the standard deviation
is equal to the square root of the variance.

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7 • 12 PORTFOLIO MANAGEMENT TECHNIQUES

Table 7.2 | A Portfolio’s Expected Alpha

Change in Cash Weight

-10.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00%
-30.00% 0.06% 0.00% -0.06% -0.12% -0.18%
-20.00% 0.08% 0.02% -0.04% -0.10% -0.16%
-10.00% 0.10% 0.04% -0.02% -0.08% -0.14%
Change in Bond Weight

0.00% 0.06% 0.00% -0.06% -0.12%

10.00% 0.02% -0.04% -0.10%
20.00% -0.02% -0.08%
30.00% -0.06%
40.00%
50.00%
60.00%
70.00%

Table 7.3 | A Portfolio’s Expected Tracking Error

Change in Cash Weight

-10.00% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00%
-30.00% 1.65% 1.21% 0.77% 0.36% 0.27% 0.65% 1.08%
-20.00% 1.25% 0.80% 0.37% 0.18% 0.58% 1.02% 1.47%
-10.00% 0.85% 0.40% 0.09% 0.51% 0.96% 1.41% 1.86%
Change in Bond Weight

0.00% 0.45% 0.00% 0.45% 0.90% 1.35% 1.80% 2.25%

10.00% 0.09% 0.40% 0.85% 1.30% 1.75% 2.20%
20.00% 0.37% 0.80% 1.25% 1.70% 2.15%
30.00% 0.77% 1.21% 1.65% 2.10%
40.00% 1.17% 1.61% 2.05%
50.00% 1.57% 2.01%
60.00% 1.97%
70.00%

Table 7.2 shows a portfolio’s expected alpha for various combinations of cash and bond allocation changes. Table
7.3 shows a portfolio’s expected tracking error for the same allocation changes. The changes shown in both tables
are restricted to plus or minus 10% increments. In both tables, the combinations that resulted in a negative stock
allocation were excluded.
The best choice is to decrease the cash allocation by 10%, decrease the bond allocation by 10% and increase the
stock allocation by 20% to 75%. These adjustments will produce an expected alpha of 0.10% per quarter.

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7 • 13

RISK BUDGETING AND SECURITY SELECTION

Using risk budgeting to help in security selection is far more difficult than using it for asset allocation. Security
selection means one of the following two things:
1. Picking specific securities within each asset class; or
2. Choosing active fund managers who will create portfolios that are different from the asset class they represent
in an investor’s portfolio.

The major difficulty that arises is the volume of calculations. In a mean-variance framework, each asset has an
expected return, risk and correlation with every other asset. This is not a problem when an investor is looking at 10
or fewer assets. However, it becomes a major problem when an investor is choosing specific bonds or stocks to buy
from the thousands available, or deciding which mutual funds to invest in from the hundreds offered for each asset
class.
A second difficulty that arises is that there is no evidence that managers can produce positive alpha on a consistent
basis over time, or that there is any systematic relationship between alpha and tracking error. If mutual fund
managers are not producing higher excess returns when they deviate from their benchmarks, it would be a moot
point to attribute expected alpha and tracking error estimates to them.
The benefit of specifying a tracking error limit is that it indicates to the investor when a proposed allocation
deviates too far from the benchmark. Risk budgeting helps prevent big negative return surprises and is designed to
protect an investor from their own greed. Risk budgeting also requires an investor to visualize active investment
decisions in terms of the risks assumed, not the returns expected. Often, it is difficult to focus on risk once a large
alpha opportunity is perceived. Risk budgeting becomes even more important as the number of potentially risky
assets in a portfolio increases. The number of potential asset combinations increases as does the uncertainty of
return outcomes. Subsequently, a portfolio manager’s need to enforce risk discipline increases.
The drawback of using risk budgeting is that an investor could have much higher return opportunities at slightly
higher risk levels. The risk level is restricted, regardless of the opportunities in the market. Investors could settle
for managers or portfolios within the tracking error limit, even though there are managers or portfolios that might
deliver considerably more returns at marginally higher risk.

ACTIVE MANAGEMENT STYLES

MPT, which is based on the theory of capital asset pricing, supports the use of passive portfolio management.
According to MPT, all financial assets, either as individual securities or portfolios, offer expected returns that fall on
the security market line (SML). Such returns are proportionate to a particular asset’s systematic risk.
To some extent, the following forms of active portfolio management conflict with the principles of MPT.
Nevertheless, while passive portfolio management is common, it is not the norm. In practice, the majority of funds
are actively managed to some degree by sector rotation, timing or momentum strategies, or by the search for
undervalued stocks.
In contrast to a passive portfolio manager, an active portfolio manager takes positions on equity values that
challenge the idea of market efficiency and the continuous equilibrium pricing of financial securities. An active
portfolio manager acts as if they can identify underpriced securities, known as the selection dimension, and can also
anticipate general market movements, known as the timing dimension.

SECTOR ROTATION
Sector rotation is an attempt to pick the best sectors. A portfolio manager identifies specific sectors that will offer
expected superior performance, then invests the majority of a portfolio’s funds in these sectors. As an example,
these sectors might include resources, financial services, high-tech, pharmaceuticals, electronics or utilities. A
portfolio manager’s task is not only to identify which sector is likely to outperform, but also when it will do so. There

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7 • 14 PORTFOLIO MANAGEMENT TECHNIQUES

is an element of short-term trading in sector rotation and timing is crucial. Sector rotation tends to be aggressive,
which is the opposite of the buy-and-hold approach.
Sector rotators believe in diversification, which is the basis of modern portfolio management, but they do not
accept all of the principles of MPT. They generally hold a number of stocks in a chosen sector (or sectors) in order
to capture the risk-reducing benefits of diversification. However, they also believe they can identify the highest
expected return-to-risk ratios in a given group of sectors. The presence of any ability to identify higher return-to-risk
opportunities contradicts capital market efficiency, which assumes no such ability exists.
If a sector rotation portfolio outperforms other portfolios in its systematic risk category, there is no consistent
basis for ascribing the portfolio’s superior performance to sector rotation per se. In fact, since a sector rotation
strategy is intended to produce a result that differs from indexes, indexes are probably inappropriate benchmarks for
measuring the performance of actively managed portfolios.

TIMING
Active portfolio management is substantially focused on timing; in other words, portfolio adjustments made
in anticipation of changes in the market’s direction. Effective timing implies that a manager can anticipate the
market’s general ups and downs. In particular, timing is premised on forecasts of protracted increases or decreases
in the market index. The objective is to take advantage of the market’s upswings and to minimize losses during its
downturns.
Timing strategies call for changes in a portfolio’s asset allocation in anticipation of general changes in the market’s
direction. The asset allocation mix can be represented as w% of the risk-free asset and (1 – w)% of a well-diversified
set of risky assets; for example, the market index. If a portfolio manager anticipates that the market index will rise,
effective timing calls for adjusting the asset allocation towards more of the index and less of the risk-free asset.
In other words, the manager needs to decrease w. However, if the manager expects the market to fall, they will
increase w.
Timing strategies can be interpreted in terms of an ex-ante Sharpe ratio, which is the expected risk premium divided
by a portfolio’s standard deviation. If the market index is expected to rise, then the ex-ante Sharpe ratio of a well-
diversified portfolio is likewise expected to rise. In this case, since the portfolio manager anticipates a higher risk
premium per unit of risk, the manager uses a timing strategy by allocating a higher proportion of the portfolio to
risky assets (or the market index) and a correspondingly smaller proportion to the risk-free asset, thus decreasing w.
In terms of timing, the key question for the portfolio manager is whether the market will move up or down. Can the
manager answer this through scientific approach or does success depend on intuition or chance? Does the answer
lie in the technical analysis of trends or in an understanding of fundamental economic influences? Although in
practice there are many approaches to market timing, none has emerged as the basis for a stable, successful and
replicable strategy.
In the short run, if an individual portfolio manager can devise and effectively apply a timing strategy, their
portfolio will inevitably outperform the market. However, if the manager’s strategy and methods become widely
known, which is likely, since success attracts attention and imitation, the strategy’s replication will soon dilute its
advantage.
Stock prices represent the capitalized value of expected future earnings. As a result, market movement is driven by
changes in expectations of future earnings across the broadest spectrum of industries, along with the ever-shifting
estimates of interest rates and the cost of equity capital. Forecasting, estimating and guessing represent more or
less scientific attempts to peer into the uncertain future of industry-sector performance.
Most timing strategies involve the analysis of leading economic and financial indicators. Economic indexes of
planned capital expenditures, inventory accumulations, housing starts or consumer spending, or financial indicators,
such as the monetary conditions index or the term structure of interest rates, often provide the basic information
that portfolio managers use to predict market movements. However, in the end, when a portfolio manager acts

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7 • 15

strategically in anticipation of a movement in the market, they act with the confidence that their view of its
direction or change in direction is superior to or at least in advance of the view of most other investors.
In summary, effective timing strategies assume superior forecasting ability. If a portfolio manager can predict
that the market will rise — and, equally important, when it will rise — the anticipated returns from the rise in the
market can be magnified by either shifting the portfolio’s weight to equities rather than bonds, or by increasing
the portfolio’s beta. Likewise, the manager can defend the portfolio against anticipated adverse movements in the
market by adjusting it in the opposite direction — that is, towards more bonds or a lower portfolio beta, or both.

VALUE, GROWTH AND CAPITALIZATION

When they are devising a strategy for investing in domestic equity markets, major plan sponsors seek specialized
portfolio managers whom they believe can add value within a particular area of expertise. These sponsors look for
managers who use methodologies that are broadly categorized as growth or value. They also distinguish managers
by the capitalizations in which they specialize. For example, a typical plan like OMERS might include a growth stock
manager who specializes in large-capitalization growth stocks and a value stock manager who specializes in large-
capitalization value stocks. The group of managers — internal or external — might also include a small-capitalization
stock manager or a further breakdown into small-capitalization growth and value stock specialists.
Traditionally, mutual fund organizations describe a fund’s investment objectives in broad terms, such as growth or
income/growth, which might be construed as value. At the same time, portfolio managers typically portray their
investment strategies broadly as growth and value. These classifications are reinforced through their common use
among consultants, plan sponsors and performance evaluators.

INVESTING FOR GROWTH

Growth stocks are characterized as stocks that are expected to grow at superior rates, whereas non-growth stocks
are characterized as stocks that grow at a rate that matches the growth in the overall economy.
Growth expectations are unobservable, so proxies are required to assess the sort of growth that an investor expects
for a stock or group of stocks. One widely used measure for assessing growth expectations is the sustainable growth
rate, which is equal to the return on equity multiplied by the retention rate.

VALUE/INCOME INVESTING
Investing for value is a style that can be characterized as non-growth. A portfolio manager’s focus is on the quality
of individual stocks, which are chosen for their stability of earnings, high dividend yield and leadership within their
industry or importance in the economy. A value fund’s objectives are income and capital preservation, and the fund
is characterized by low volatility. Those who manage value portfolios have conservative expectations for capital
appreciation to supplement income flows from dividends or interest. High-yielding blue-chip stocks will usually
make up a value/income equity portfolio.
Mutual funds that are designed for value are often characterized as balanced funds. Such funds commonly include
bonds and blue-chip equities. Mixing bonds and stocks can help reduce the price volatility of a fund’s units because
of the low correlation of returns between the two asset classes. There will be fewer opportunities for capital
appreciation and the fund will produce income in the form of both interest and dividends.

CAPITALIZATION SIZE
Financial research has uncovered an interesting relation between equity returns and firm size. The smallest
capitalization firms (small caps) generate consistently higher returns on a conventional risk-adjusted basis. This
so-called size effect has been retested a number of times in a number of ways, and it seems to hold up remarkably
well.9, 10

9
Avner Arbel and Paul Strebel, “The Neglected and Small Firm Effects,” Financial Review 17 (1982): 201–18.
10
Marc R. Reinganum, “Abnormal Returns in Small Firm Portfolios,” Financial Analysts Journal 37 (1981): 52–56, 71.

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7 • 16 PORTFOLIO MANAGEMENT TECHNIQUES

The size effect is an anomaly to the capital asset pricing model (CAPM) and MPT. When the size effect was first
reported, many experts tried to reconcile the findings with the theory that it challenges. Because it is an important
issue for many portfolio managers, it is useful to briefly review some of the arguments that have emerged over the
years, including the following:
• One explanation for the small firm effect points to weaknesses in the statistical methods used to measure
systematic risk. The argument is that small firm betas are biased downward, making such betas appear
smaller than they truly are. Two reasons for the downward bias have been suggested. First, compared to larger
firms, small firms tend to be thinly traded, which introduces gaps in the data series. These gaps produce beta
estimates that understate the true value.
• Second, dealing with data as opposed to technique, many small firms have become smaller, or downsized, as a
result of strategic business decisions. These smaller firms are fundamentally different and typically riskier than
they previously were. However, since beta is measured from historical data, the old “larger firm” characteristics
remain embedded in the data. This so-called “errors-in-variables” problem would likewise lead to a downward
bias in the estimation of beta.
• Another reason why the CAPM may underestimate expected returns for small firms is linked to liquidity.
Investors demand a higher expected return for less liquid stocks, because trading them involves higher
transaction costs. There is substantial evidence that small stocks have higher bid-ask spreads. Furthermore,
less liquid stocks are more vulnerable to price impacts that result from large transactions. These considerations
suggest that the higher returns on smaller stocks are in part compensation for illiquidity.

In the meantime, while financial researchers wrangle about the reasons, the so-called size effect has spawned a
number of small-capitalization funds. Indeed, whether the excess returns are real or phantom, or whether they
compensate for higher transactions costs and illiquidity or not, smaller firms offer an unambiguous advantage
through diversification as the small-capitalization companies category’s returns are less than perfectly correlated
with the rest of the market.

ACTIVE PORTFOLIO CONSTRUCTION

ENHANCED ACTIVE EQUITY INVESTING
Long-only portfolios — in which short selling is not allowed — are restricted in their ability to underweight
securities by more than the securities’ benchmark weights. The most a portfolio manager can do is not own the
security. Because the contribution of most securities in many benchmarks is relatively small, there is almost no
opportunity to significantly underweight unattractive securities in long-only portfolios. However, enhanced active
equity investing11 relaxes the long-only constraint, while maintaining full portfolio exposure to market return and
risk.
In enhanced active equity investing, an active portfolio manager overweights the securities they expect will
outperform the benchmark, and underweights those they expect will underperform the benchmark. Any security
can be overweighted to achieve a significant positive active weight, but most securities cannot be underweighted
enough to achieve a significant negative active weight.
Allowing a portfolio manager to short stocks gives them more room to underweight overvalued securities and
enhances their ability to produce more attractive active equity returns. Short selling also reduces a portfolio’s equity
market exposure to systematic risk. Market exposure can be restored by matching the amount of stocks that are
sold short with additional purchases of stocks that are held long.

11
Bruce Jacobs and Kenneth Levy, “Enhanced Active Equity Strategies,” The Journal of Portfolio Management (Spring 2006): 45-55.

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There are three main reasons why an enhanced active equity manager may want to short securities, as follows:
1. To take advantage of a singular opportunity: Shorting due to a unique alpha opportunity is straightforward. An
enhanced active manager shorts stocks based on the belief that a stock’s price will fall either in absolute terms
or relative to the market. These types of shorts are based on stock-specific events, catalysts or a company’s
fundamental characteristics.
2. To exploit relative returns between two stocks: Pairs trading involves simultaneously buying one security and
shorting another in the same industry with similar business or fundamental characteristics. For example,
consider two companies in the insurance industry: Manulife (MFC) and Sun Life (SLF). An enhanced
active equity manager buys MFC stock and shorts SLF stock based on their expectations that MFC’s stock
performance will positively diverge from that of SLF’s. Or the manager may short MFC’s stock and buy SLF’s
stock given the belief that the performance of these two stocks will converge to a historical norm.
3. To hedge out industry exposure in order to isolate an alpha return: In order to hedge out industry exposure to
isolate a stock-specific alpha signal, a portfolio manager may buy MFC’s stock and short SLF’s stock to isolate
exposure to a segment of business maintained by MFC but not SLF. Managers engaging in these types of shorts
are often interested in the company but not in the industry in which it operates.

Therefore, enhanced active equity portfolios are a variation of actively managed long-only portfolios. They are
constructed by selling short selected stocks and reinvesting the short sale proceeds into additional long positions.
For example, a manager with $100 of capital could sell short $30 of securities and use the $30 proceeds to purchase
$130 of long positions, which results in a 130–30 portfolio. The portfolio has a net equity exposure of $100 and its
capital remains fully exposed to the market, while the beta remains close to 1.00. Similarly, the manager can create
portfolios with other long–short combinations — 120–20, 150–50 and so on. Enhanced returns come from both
leverage and short selling.
Figure 7.1 (below) illustrates the mechanics of an enhanced active equity portfolio. For a 130–30 portfolio, the
manager deposits $100 in an account with a prime broker. The prime broker provides the back office services —
securities lending, financing, custody and clearing, and so on — to enable the short selling to take place. Next, the
prime broker arranges for the manager to borrow directly from the stock lender the $30 worth of securities that
the manager sells short. The $30 in proceeds from the short sales, with the initial $100, is used to purchase $130
of securities. The $30 in long positions is used to collateralize the borrowed stocks, which are held in a stock loan
account.

Figure 7.1 | An Enhanced Active Equity Portfolio

1 2 3 4
Client deposits Manager $30 securities $30 proceeds
$100 with her borrows $30 are sold short from short sale
investment securities from go back to the
manager a stock lender manager

7 6 5
Stock lender $30 long stock $130 used by
given to stock manager to
lender as purchase stock
collateral for long
borrowed stock

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7 • 18 PORTFOLIO MANAGEMENT TECHNIQUES

In an enhanced active equity portfolio, short positions are likely to be smaller-capitalization stocks. These are
the securities that cannot be meaningfully underweighted until they are sold short. An enhanced active equity
portfolio’s short positions will generally have a smaller average capitalization than the benchmark. In order to offset
the small-capitalization bias, the portfolio’s long positions will also have a similar small-capitalization bias. By
establishing offsetting long and short positions, the entire portfolio will approximate the underlying benchmark’s
average capitalization. The enhanced active equity portfolio can benefit from greater diversification across the
opportunities provided by the individual stocks in the benchmark. Greater diversification across underweight and
overweight opportunities should result in greater performance consistency relative to the benchmark.
The advantage of being able to sell stocks short may be greater than the skill of buying undervalued ones. For
example, earnings disappointments may have a stronger impact on prices than positive earnings surprises. Portfolio
managers who are skilled at forecasting earnings disappointments can better use their abilities if they can increase
security underweights with short positions. Furthermore, there may be an information advantage to shorting
stocks, especially small-capitalization ones.
Most analysts are bullish in their recommendations, underrepresenting poorly performing companies. Also, small-
capitalization stocks are under-researched versus their large-capitalization counterparts. The underweight constraint
of long-only portfolios, the limited amount of short selling that takes place and the tendency for brokers to favour
buy recommendations over sell recommendations all suggest that overvaluation may be more common and of
greater magnitude than undervaluation.
Institutional investors may be more comfortable with 130–30 strategies than with alternative investment strategies
that use derivatives or exotic investments. Enhanced active equity construction allows them to use familiar equity
allocations.

LONG–SHORT INVESTING
Market-neutral long–short investing, which is also known as market-neutral investing or long/short in the following
section,12 is a portfolio construction technique designed to take greater advantage of information within equity
markets. The difference between market-neutral management and more traditional active management is that
market-neutral management eliminates the market’s effect and is more aggressive in its stock shorting, amplifying
the approach by using leverage.
There are two strategies to use in market-neutral investing: absolute return and alpha portability. Long–short is an
absolute return strategy with return and risk expectations in excess of those for Treasury Bills (T-bills). Within a
portfolio, many managers use market-neutral investing as part of a strategic allocation to alternative investments.
A benefit of long–short equity investing is the portability of its alpha. Using futures, the long–short alpha can be
applied to any asset class. (Alpha portability is discussed later in this chapter.)
In the construction of a long-short portfolio, a portfolio manager uses the starting capital to purchase securities,
which is the long portion. The second part of the strategy involves short selling securities.
In a long-short equity strategy, there are two primary sources of return. The first is the return from the long–short
positions, which has the following two components:
1. The long portfolio, where the portfolio manager is a buyer of stocks.
2. The short portfolio, where the long–short equity manager borrows stocks from another manager through
securities lending channels, then sells the stocks to generate the short portfolio.

The value added comes from the long portfolio’s return being greater than the short portfolio’s return.
In a long-short strategy, the goal of active management is to generate a positive spread between the long and short
portfolios. The second source of return comes from the strategy’s T-bill component. When the manager sells the

12
Barra RogersCasey, “Market Neutral Investing”, 2000.

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7 • 19

stocks short, they receive proceeds from the sale. These proceeds are reinvested in T-bills and become the second
source of return, as well as the strategy’s benchmark.
Table 7.4 illustrates that properly constructed long–short strategies can provide alpha in any market environment.
In the up-market scenario, the S&P 500 Index returned 25%. In this case, the long portfolio’s 18% positive return
trailed the S&P 500 Index, which is quite typical of active managers in an extremely strong market. The short
portfolio rose 12%, a negative return for a short manager. The net result is a +6% spread between the long and
short portfolios. When combined with T-bill returns, the strategy provides a 10% total return.

Table 7.4 | Long–Short Strategies and Their Effect on Alpha

Up Market Down Market Flat Market Perverse Spread

S&P 500 Index 25% -25% 0% +20%
Long-Short Strategy
Long Portion +18% -16% +7% +15%
Short Portion -12(+12)% +21(-21)% -2(+2)% -21(+21)%
Long/Short Spread +6% +5% +5% -6%
T-Bill Return +4% +4% +4% +4%
Total Return +10% +9% +9% -2%

Likewise, in the 25% down market, the long portfolio lost 16% and the short portfolio fell 21%, a positive 5% net
return for the manager. Again, the overall result is a 9% total return. In a flat market, the long position gained 7%
and the short position gained 2% for a 5% spread. Finally, when the spread between the long and short portions is
negative, which is referred to as a perverse spread, the returns of long–short strategies will trail T-Bills. As illustrated
in Table 7.4, one of the most attractive features of long–short strategies is that it does not matter what the S&P 500
Index does, as long as a positive spread exists between the long and short portfolios. The return is purely active,
reflecting the manager’s stock-picking skills.

THE BENEFITS OF LONG–SHORT INVESTING

Market-neutral investing provides several benefits. First, the returns the strategy generates are independent of the
market’s direction. Long–short returns are broadly uncorrelated not only to stocks and bonds, but also to equity-
style returns and to the active returns of equity managers. Another benefit is that long–short equity strategies use
information more efficiently, which results in higher risk-adjusted returns. In addition, the alpha that long–short
equities generate is portable to other asset classes, which can be beneficial to rebalancing and asset allocation.
Furthermore, long–short investing is said to make more efficient use of information. Portfolio managers develop
elaborate processes that rank the attractiveness of stocks from highest to lowest using various inputs. However,
long-only portfolio managers only use the top portion of the ranking output and discard the information about the
worst-ranked stocks. The short side of a long–short portfolio takes advantage of this discarded information.
Much of the investment community is focused on which stocks to buy, instead of which stocks to sell short. An
argument can be made that there are greater information inefficiencies on the short side of a portfolio. Long-
only managers are inherently constrained to the size of any given security’s underweight position, as its largest
underweight versus the benchmark is constrained at 0. A long-only manager must maintain stock holdings with
market average returns merely to maintain benchmark exposure.
In contrast, a long–short manager is not constrained by a stock’s benchmark weight and can have a greater
underweight in that security. Not only does long–short investing use more information, but some of the less
efficient information is used and provides greater opportunity. Therefore, long–short portfolios not only have the

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7 • 20 PORTFOLIO MANAGEMENT TECHNIQUES

value added or alpha of a typical long portfolio, but also the value added of the short side. This “double alpha”
provides better risk-adjusted returns than long-only strategies.
Another positive attribute of long–short equity strategies is the flexibility provided in asset allocation and
implementation. The alpha that is generated by a long–short equity strategy can be left as a cash-plus-alpha
strategy, or the alpha may be “ported” to any other asset class using futures. The alpha’s “portability” enables
managers to increase or decrease their stock, bond or cash allocations — or a combination thereof — or to rebalance
their fund structure as required through the use of an alpha-generating investment vehicle. This can be done more
cost-effectively, because these instruments allow the manager to transact without actually buying or selling
individual securities. Just as with long–short equities, the use of portable alpha strategies may in fact lower the
costs of an asset allocation or rebalancing policy without giving up alpha potential. The details of implementing a
portable alpha strategy are discussed later in this chapter.

ISSUES WITH LONG–SHORT INVESTING

In addition to the benefits of long-short investing, there are also some drawbacks.
Long–short equity strategies are more expensive to maintain than long-only ones. Not only are the management
fees higher, as most market-neutral strategies charge 1% plus some share of the profits, but also the turnover
is higher and the portfolios are costlier to implement. In addition, trading is more expensive in market-neutral
strategies, as there is usually at least twice as much of it, and short selling is clearly more complicated. In order to
address the implementation costs, long–short managers use principal or packaged trades instead of agency trades.
In principal trades, the manager packages all of the trades together and sends to brokers the characteristics of the
entire basket of stocks on which to base their bids. Generally, the lowest price wins.
When using a long–short strategy with futures, there is potentially an additional expense. Investing in futures
requires firms to manage rollover risk. Liquidity can be an issue in less popular indexes, which can make futures
more expensive to trade.
Another drawback is that the capacity of long–short equity strategies is limited. Investment managers face liquidity
constraints on a portfolio’s short side. More often than not, stocks that are sold short in a market-neutral portfolio
will fall into the small-capitalization end of the size spectrum. Therefore, market impact becomes a significant cost.
Also, stocks may have to be repurchased if the lender needs their shares back. These risks are generally higher in
Canada than in the U.S., because the Canadian market’s capitalization is far smaller.
In addition, if the short seller is selling dividend-paying stocks, they must pay dividend reimbursements,
which depend on a stock’s cash dividends and only occur for stocks that are short on their ex-dividend dates.
Reimbursements are necessary because there are two owners of a shorted stock: the original owner who loaned the
stock to the short seller and the third party who purchased the stock from the short seller. Because the third-party
receives the dividend from the issuer, the short seller must reimburse the original owner for the “lost” dividend.
The cost per share of the dividend reimbursement does not vary with the number of shares that are shorted, as the
dividend per share is fixed and does not change with the number of shares sold short. In contrast, the per share cost
of the stock loan fee could rise if the demand to borrow shares goes up. As a long–short portfolio increases in size, it
is possible it could face higher fees for shorting stocks, and at some point, these higher fees could have a significant
negative impact on performance.
The more pressing issue is the long-short strategy’s use of derivatives and leverage, but this can actually be avoided.
Unless the alpha is going to be “ported” to a different asset class, derivatives do not need to be used. In their
standard form, long–short equity strategies do not use derivatives. Leverage is typically a standard component of
the strategy. However, managers who are concerned with leverage, or those with guideline limitations on leverage,
have avoided this issue by implementing only 50% of their allocation to long–short strategies, thus reducing the
leverage from 2:1 to 1:1.

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7 • 21

PORTABLE ALPHA STRATEGY

Conventional, long-only active investment managers try to build returns from two sources: exposure to systematic
or market risk (beta) and exposure to unsystematic or active risk (alpha). Managers do not take separate risk
exposures on these decisions; rather, when constructing a long-only portfolio, they assume a bundle of systematic
and active risks with each security selection. Thus, a typical active manager’s portfolio could have a beta of less or
more than 1.0 merely as a consequence of alpha exposure. A true active strategy does not depend on the market’s
direction. For example, a pure stock picker’s portfolio would have a beta of 1.0 relative to a market index, and the
value added would only come from security selection.
Portable alpha13 is the process of using derivatives or short selling to separate the alpha and beta return decisions,
and apply the alpha to portfolios made up of other asset classes. In effect, portable alpha enables a manager to
budget risk and increase alpha without drastically changing a portfolio’s asset allocation mix.
A portable alpha strategy consists of three components, as follows:

The beta portfolio As mentioned earlier, beta is the systematic risk or the extent to which an investment
moves with the market. Beta represents the passive returns of long or short exposures
to the market or a mix of these exposures in a portfolio. The benchmark or index
representing the beta should be easily replicable.

The alpha portfolio (or Alpha is the measure of a manager’s skill in adding value by taking active risk, which is
alpha engine) any non-benchmark–like security exposure, such as a stock’s underweight in relation to
its index weight. An alpha portfolio should be three things: (1) unrelated to its underlying
market, (2) independent of its market direction and (3) absolute in nature (to generate
positive returns).

The cash portfolio This component comes from an investor’s initial investment, from the proceeds of
securities sold short after hedging or investing, or from the cash collateral required for
margin on derivative exposures.

A portable alpha strategy is where an alpha portfolio is made beta neutral and added to a beta portfolio. Therefore,
the alpha is transported or “ported” to the beta portfolio. Remember that the alpha and beta portfolios each
represent different asset classes (see Figure 7.2 below).

Figure 7.2 | Portable Alpha

Remove
Systematic Systematic Risk
Risk Asset 1
+ +
Unsystematic
Risk Asset 1 Asset 2 Asset 1 Asset 2

Systematic Unsystematic Systematic

Risk Risk Risk

1. Combining a long-only fund that produces consistent alpha with short positions in futures contracts or
exchange-traded funds (ETFs) that represent the underlying beta in an alpha portfolio; or
2. Creating a portfolio that has simultaneous long and short positions in exactly offsetting dollar amounts to
create beta neutrality.

13
Edward Kung and Larry Pohlman, “Portable Alpha – Philosophy, Process & Performance”, 2004.

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7 • 22 PORTFOLIO MANAGEMENT TECHNIQUES

EXAMPLE
Implementing a Portable Alpha Strategy
Assume a manager holds a large-capitalization equity portfolio indexed to the S&P 500 Index. Also assume
there is a separate active small-capitalization portfolio that has added alpha relative to the Russell 2000 Small-
Cap Index. Large-capitalization stocks are expected to outperform small-capitalization stocks over the next 12
months. If the manager wants to increase his small-capitalization exposure, he has to give up the incremental
large-capitalization returns. If the manager wants to avoid small-capitalization exposure, he will have to give up
the alpha from the small-capitalization portfolio.
To get the small-capitalization manager’s stock selection skills and to maintain exposure to large-capitalization
stocks:
1. The large-capitalization manager sells 20% of his portfolio to fund the purchase of S&P 500 Index futures
and the small-capitalization portfolio. The S&P 500 Index futures are purchased in a notional amount that
is sufficient to maintain the portfolio’s original large-capitalization exposure.
2. Futures contracts on the Russell 2000 Small-Cap Index are sold in an amount that is approximately equal
to the value of the small-capitalization portfolio in order to neutralize the small-capitalization beta in the
portfolio. What remains is the difference between the small-capitalization portfolio’s return and the small-
capitalization index’s return — the alpha.

The combined futures positions — one long and one short — allow the portfolio to transport alpha from the
small-capitalization portfolio to the large-capitalization asset class (see Figure 7.3).

Figure 7.3 | Implementing a Portable Alpha Strategy

Unchanged Small Cap Alpha

80% 20% 80% 20% Small Russell

Large Large Large S&P Cap 2000
Cap
+ Cap
= Cap
+ Index
+ Portfolio
- Index
Equity Equity Equity Futures Futures

Funding

Since the Canadian derivative markets are much smaller and limited, a Canadian portfolio manager might instead
use total return swaps. The manager can contract with a swaps dealer to exchange small-capitalization equity
returns for large-capitalization equity returns. The swap contract might specify that the manager pay quarterly
over the contract term an amount that is equal to the S&P/TSX SmallCap Index’s return multiplied by the small-
capitalization portfolio’s value. In return, the swap dealer pays the manager the S&P/TSX Composite Index’s
return multiplied by the small-capitalization portfolio’s value.

WHAT TO USE AS ALPHA

Most investment strategies can be converted into portable alpha strategies, provided there is alpha to begin with.
Efficient asset classes do not generate enough alpha to be worthwhile. Better alpha can be found in less efficient
markets, such as small-capitalization equities.

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An investor should be able to modify the underlying beta. They also need a hedging vehicle to eliminate market
exposure. There should be an index future, swap contract or ETF available with enough liquidity. Some investment
strategies, such as real estate and private equity, do not lend themselves to portable alpha strategies because they
have no hedging vehicle. Table 7.5 provides a list of strategies that work well for portable alpha strategies.

Table 7.5 | Strategies That Can Be Turned into Portable Alpha Strategies

Aggressive growth Managed futures

Convertible arbitrage Market-neutral arbitrage
Currency Market-neutral equity
Dedicated short bias Market timing
Distressed short bias Opportunistic
Emerging markets Multi-strategy
Event-driven Variable
Fixed income arbitrage Short selling
Fund of funds Special situations
Income Value
Long–short equity Volatility arbitrage

THE BENEFITS OF PORTABLE ALPHA

Portable alpha has a number of benefits. By liberating the security selection return from the benchmarks to
which the securities belong, portable alpha allows investors to maximize both manager selection and asset class
allocation. The decision to maximize alpha no longer needs to be bundled with an investor’s asset allocation
decision, as they can separately pursue the best opportunities in asset allocation and security selection.
Portable alpha may also liberate portfolio managers if they have neglected their own areas of skill in order to pursue
the returns their clients favour. Portable alpha frees managers to focus on the universes within which they feel they
have the greatest skills and the highest potential to add value. This independence should ultimately translate into
enhanced performance for their clients.
By divorcing security selection decision from the asset allocation decision, portable alpha gives investors increased
flexibility in structuring an overall fund. Reaching for greater alpha returns does not need to translate into higher
beta risk. This added flexibility should translate into enhanced performance. In a similar fashion, the manner in
which a portfolio manager constructs an individual portfolio can afford them increased flexibility to pursue excess
returns from security selection.
When it is added to a portfolio, portable alpha can reduce the portfolio’s volatility and increase its efficiency.
Strategies that employ portable alpha strip the systematic risk from the securities in the alpha engine. What
remains is uncorrelated to other asset classes. Also, due to the long and short nature of some of the investments,
portable alpha strategies have broader investment opportunities and should have better risk/return profiles than
conventional long-only strategies.
Finally, portable alpha offers investors improved control over risk budgeting. An investment policy and capital
market forecast allows for a limited amount of risk over an investment horizon. By separating the alpha and beta
decisions, any decisions impacting alpha do not adversely affect the level of beta risk. As such, an investor has better
control over the amount of residual and systematic risk.

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ISSUES THAT ARISE WHEN IMPLEMENTING AN ALPHA ENGINE

Arguably, an alpha engine, which is a source of unsystematic returns, is the most important piece of a portable
alpha solution. When selecting an alpha engine, the objective is to find a consistent and positive source of excess
return (alpha) that has a low correlation with the beta to which it is being transported.
When selecting an alpha engine, an investor may err in one of the three following ways:
1. By selecting an inconsistent, unsustainable alpha engine;
2. By using an alpha engine that is inappropriate to meet their desired objectives; or
3. By incorrectly estimating the magnitude and volatility of betas embedded in an alpha engine.

First, to be recognized as skillful, a manager must deliver positive, consistent and sustainable alpha. Frequently, an
investor chooses a manager based on an expected high alpha without considering the reliability of the manager’s
track record. To assess this, an investor must examine the manager’s tracking error, which is the standard
deviation of the difference in the manager’s returns versus those of the benchmark. High tracking errors reduce
the attractiveness of high historical alphas, because they reduce the likelihood that high alphas will be achieved
consistently in the future. An investor who chooses a manager with a high tracking error relative to the expected
alpha risks being surprised with subpar returns. Managers who appear to be generating alpha may be providing beta
that is disguised as alpha. This can occur with managers who are simply leveraging fairly priced assets, or with those
who use highly situational strategies that pay a fair premium for infrequent events. These excess returns are not
alpha.
Second, even when investors manage to find a true, consistent, positive and sustainable source of alpha, they
may face risks because they did not fully consider their objectives when choosing the source of alpha. The alpha
engine must provide enough returns to meaningfully impact an investor’s portfolio, while also avoiding imprudent
exposure to risks.
Alpha is scarce in highly efficient markets, and to deliver significant amounts of it, managers must implement a
more concentrated strategy. However, investors must also be willing to accept the significant associated risks. They
must find a balance between strategies that do not allow significant shifts among asset classes and those that are
highly aggressive.
Finally, ideal alpha engines have consistently low embedded betas; but, as with any portfolio, the betas can be
expected to change over time. Investors who do not consider embedded betas when selecting an alpha engine risk
overpaying for that portion of their return. For example, the average market-neutral hedge fund has significant
embedded beta exposure. Paying hedge fund fees for this type of beta exposure diminishes the benefits of using
portable alpha.

DERIVATIVES STRATEGY
Alpha transport may face interference in the form of unavailability or illiquidity of derivatives instruments. In
particular, futures contracts are not traded on all asset class benchmarks that may be of interest to investors, and
even when they are available, the contracts may not have enough liquidity to support institutional-size needs.
When investors face insurmountable interference in transporting via futures, they can turn to the over-the-counter
(OTC) swaps market. Swaps can be customized to meet most investors’ needs.
Although the price of futures contracts will converge to the price of the underlying index at expiration, futures-
based strategies may not always provide the underlying index’s exact performance for many reasons.
First, although futures contracts are fairly priced to reflect the current value of an underlying spot index and are
adjusted for the forward interest rate and the dividend value of an underlying index, actual futures prices can diverge
from fair price. Less liquid contracts tend to experience greater tracking error. This type of basis risk can add to or
subtract from the performance of derivatives relative to an underlying index.

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The performance of futures may also differ from an underlying index’s performance because of inefficiencies from
margin costs and the need to roll over near-term futures contracts. Because the purchase or short sale of futures
contracts involves a deposit of an initial margin — generally about 5% of the value of the underlying stocks — plus
daily marks-to-market, a small portion of the investment funds will have to be retained in cash. This will earn
interest at a short-term rate, but will represent performance drag when the rate earned is below the interest rate
that is implicit in the futures contracts.
Swaps, which are another type of derivative, reduce some of the risks of missing a target index. They generally
require no initial margin or deposit, and the term of the swap contract can be specified to match an investor’s
time horizon. In addition, swap counterparties are obligated to exchange payments according to contract terms;
therefore, payments are not subject to fluctuations in the underlying benchmark’s value, as is the case with futures
contracts.
However, swaps do entail price risk. A swaps dealer will generally charge a spread. For example, a party wanting to
exchange the Russell 2000 Index’s return for the S&P 500 Index’s return may be required to pay that of the Russell
2000 Index plus a few basis points.
In general, the price of a swap will depend on the ease with which the swap dealer can hedge it. If a swap dealer
knows they can lay off a swap immediately with a counterparty demanding the other side, the dealer will charge
less since they do not have to incur the risks associated with hedging its exposure.
Swaps also entail some credit risk, as unlike futures contracts, they are not backed by exchange clearinghouses.
The absence of an initial margin deposit and daily marking-to-market further increases credit risk. Although credit
risk will generally be minimal for an investor or manager swapping with a large, well-capitalized investment bank,
the credit quality of counterparties must be closely monitored to minimize exposure to potential default. Default
may prove costly, and as swaps are essentially illiquid, it may be difficult or impossible to find a replacement for a
defaulting counterparty.

COMPARING PASSIVE AND ACTIVE PORTFOLIO CONSTRUCTION

TECHNIQUES
Table 7.6 compares enhanced active equity strategies with long-only and long–short strategies in terms of their
active weights and returns. A portfolio’s capital is allocated to seven securities, each with different degrees of
attractive or unattractive returns. The first column gives each security’s expected active return, and the second
column gives each security’s benchmark index weight. The expected contribution to active return is the product of
active weight multiplied by the expected active return. For any portfolio, the sum of the active weights should equal
zero, as capital is freed up from underweight securities to fund the overweight positions.

Table 7.6 | Comparing Active and Passive Equity Portfolio Construction Techniques

Market-Neutral
Enhanced Index Equity Enhanced Active Equity Long–Short Equity
Index Equity Portfolio Portfolio Active Weight Portfolio Portfolio (120–20) Portfolio
Security Benchmark I
Security Return (%)

Index Weight (%)

Expected Active

Expected Contribution

Expected Contribution

Expected Contribution

Expected Contribution

Expected Contribution
to Active Return (bps)

to Active Return (bps)

to Active Return (bps)

to Active Return (bps)

to Active Return (bps)

Portfolio Weight (%)

Portfolio Weight (%)

Portfolio Weight (%)

Portfolio Weight (%)

Portfolio Weight (%)

Active Weight (%)

Active Weight (%)

Active Weight (%)

Active Weight (%)

Active Weight (%)

3 8 8 0 0 26 18 54 50 42 126 55 47 141 60 60 180

2 15 15 0 0 33 18 36 40 25 50 50 35 70 25 25 50

1 23 23 0 0 32 9 9 10 -13 -13 15 -8 -8 15 15 15

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7 • 26 PORTFOLIO MANAGEMENT TECHNIQUES

0 27 27 0 0 9 -18 0 0 -27 0 0 -27 0 0 0 0

-1 13 13 0 0 0 -13 13 0 -13 13 0 -13 13 -15 -15 15

-2 12 12 0 0 0 -12 24 0 -12 24 -15 -27 54 -25 -25 50

-3 2 2 0 0 0 -2 6 0 -2 6 -5 -7 21 -60 -60 180

Total Active Returns 0 142 206 291 490

The index equity portfolio does not underweight or overweight any security. The portfolio exactly matches the
benchmark’s returns.
The enhanced index equity portfolio can take small active positions by no more than plus or minus 18%. Note that
the sum of the positive active weights in the enhanced index equity portfolio (45%) equals the sum of the negative
active weights (–45%).
The enhanced index equity portfolio is overweight the most attractive stocks by 18%, but the portfolio manager’s
ability to underweight the most unattractive stock is constrained by its benchmark weight. The portfolio manager
could underweight this stock by only 2%, even though it has the same degree of expected active returns as the
most attractive stock (3%). Expected contribution to active returns over the index strategy is only 142 basis points.
The active weight equity portfolio manager is allowed to have a higher active security weight. Thus, the active
weight portfolio pushes its active weight to 67% of its capital. The portfolio is overweight the two most attractive
stocks by 42% and 25%, respectively, increasing the contribution to its expected active return to 206 basis points.
But the underweight of the two most unattractive stocks are again constrained by their benchmark weights of 2%
and 12%, respectively.
The constraint against short selling hampers all long-only portfolios in their ability to overweight stocks. None of
the long-only portfolios can take large underweight positions in the two most unattractive stocks, as holding a
zero weight in these stocks frees only a relatively small amount of funds to purchase the attractive stocks. Much of
the capital to fund the overweight positions comes from underweighting the only slightly unattractive or neutrally
ranked stock.
The enhanced active equity portfolio sold short securities equal to 20% of capital and purchased long positions
equal to 120% of capital, so its capital is leveraged 1.4 times. Furthermore, the 20% sold short and 20% invested
long are all in active positions.
The enhanced active equity portfolio can take larger underweight and larger overweight positions than the
enhanced index or active weight portfolios because it can sell short. Therefore, the enhanced active equity
portfolio’s long positions can contribute more to its return. The portfolio can also underweight the two most
unattractive stocks by more than their benchmark weights, which increases their expected contributions to active
returns to 291 basis points. Now, the most unattractive and attractive stocks can add meaningful expected active
return.
The more short selling that is allowed, the more fully the managers can exploit information on expected security
returns. This is reflected with the market-neutral long–short equity portfolio. A market-neutral portfolio invests
100% of capital long and sells 100% short for a two-times leverage factor.14 The long and short positions offset
market exposure so that the portfolio has no market benchmark risk or return. All the return is from alpha. At 490
basis points, the portfolio’s expected contribution to active return is the highest of all of the strategies.
As Table 7.6 shows, the market-neutral long–short equity portfolio can take short positions that are equal in
percentage terms to the long positions, and capture the equivalent amount of expected return. This portfolio has no
exposure to the underlying benchmark and does not capture market return or risk.

14
The method used to calculate leverage is to add the fund’s short value to the long value and divide by the capital invested, i.e. (100 long +100
short)/100 capital = 2.

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THE ENHANCED PRIME BROKERAGE STRUCTURE

The creation of enhanced active equity portfolios depends on prime brokerage structures that allow managers
to establish a stock loan account with a broker. The manager is not the prime broker’s customer, as would be the
case with a regular margin account, but instead is a counterparty in the stock loan transaction. This is an important
distinction. Managers can use the stock loan account to directly borrow the shares they want to sell, and the shares
they purchase serve as collateral for the ones they have borrowed.
In a margin account, the broker is an intermediary between the stock lender and the manager. The manager places
the proceeds from the short sale of the securities with the lender. In the stock loan account, the broker arranges the
collateral for the securities’ lenders, providing cash, cash equivalents, securities or letters of credit. This means that
the proceeds from the short sales are available to the manager to purchase securities long.
Furthermore, in a margin account, where the manager is a customer, the broker arranges to borrow the shares the
manager wants to sell short. These borrowed shares are marked-to-market daily. If the borrowed shares rise in price,
the manager must provide the lenders with additional cash collateral to make good on market losses. If the short
positions fall in price, the lenders return the cash to the manager. The manager with a margin account must retain
a cash reserve to meet such demands. This reserve does not generate investment returns, although it does earn
interest.
In a stock loan account, the borrowed shares are collateralized by the long securities the manager holds, not by the
short sale proceeds, which eliminates the need for a cash reserve. Therefore, all of the proceeds of short sales and
any other available cash can be redirected towards long purchases.
In exchange for arranging shares to borrow and handling the collateral, the prime broker charges an annual fee that
is equal to about 0.50% of the market value of the shorted shares. Fees may be higher for shares that are harder to
borrow or for smaller accounts. For a 120–20 portfolio, the fee as a percentage of capital is about 0.10%. The broker
also generally obtains access to the shares the manager holds long, up to the dollar amount the manager has sold
short, without paying a lending fee. The broker can lend these shares to other managers to sell short. In turn, the
manager can borrow the shares the broker can pledge from other managers, as well as the shares the broker holds in
its own accounts and the ones it can borrow from other lenders.
Finally, as the manager is a counterparty in a stock loan account, rather than the broker’s customer in a margin
account, the fact the manager is borrowing shares to sell short is not subject to IIROC regulations. Instead, the
manager’s leverage is limited by the broker’s own internal lending policies. In theory, an enhanced active equity
manager could run a 200–100 portfolio holding long positions equal to 200% of its capital and selling short
positions equal to 100% of its capital, or maintain an even more highly leveraged structure.

THE USE OF DERIVATIVES IN EQUITY PORTFOLIO MANAGEMENT

One of the many conclusions of MPT is that diversification can reduce a portfolio’s unsystematic risk to zero,
but that systematic risk cannot be diversified away. With the advent of equity index derivatives, this conclusion
might be modified to read as follows: diversification can reduce a portfolio’s unsystematic risk to zero while
still maintaining an optimal portfolio return, and systematic risk cannot be diversified away without sacrificing
a portfolio’s level of return. This section will deal with the two applications of derivatives in equity portfolio
management: risk reduction — that is, hedging — and changing an asset mix.

HEDGING A PORTFOLIO WITH EQUITY INDEX DERIVATIVES

A hedged portfolio is a portfolio with no exposure to a specific risk. Since a portfolio with no risk should earn a risk-
free rate, why should portfolio managers hedge with derivatives? Why do they not invest in zero-risk T-Bills to start
with? The answer is that managers may wish to eliminate risk for only short periods of time. If a portfolio manager
anticipates an increased level of volatility and a potential for a market downturn, switching a portfolio’s holdings

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from risky to risk-free assets (and eventually back again) can be time-consuming and very costly. Derivatives offer
portfolio managers a quick and cost-efficient alternative to a large portfolio overhaul.

HEDGING WITH EQUITY INDEX FUTURES

Portfolio managers can use equity index futures for both short and long hedging. Reducing a portfolio’s systematic
risk involves the implementation of a short hedge, which is implemented by selling equity index futures. If a
manager’s opinion on the market is correct, the actual portfolio position will show a loss, while the short futures
position will show an offsetting profit. The futures position will afford protection against overall market declines for
as long as the manager feels this risk is significant and they keep the position open. The disadvantage is that a short
hedge will be a performance drag if the market rises.
Portfolio managers typically establish long hedges when they want to add positions to a portfolio but do not yet
have the cash available. A long hedge is implemented by buying equity index futures, which gives managers market
exposure on an interim basis. When the cash becomes available, managers can replace the futures position with the
actual stocks that they want to add. Long hedges are frequently employed by equity index mutual funds to avoid
cash drag. Managers who receive a large inflow of cash on a particular day can invest it more quickly and easily by
purchasing index futures than by purchasing individual securities. For convenience and a lack of cash drag, managers
accept the risk of also being exposed to market declines.
The first step in implementing a hedge, whether long or short, is to determine the total dollar value to be hedged.
The second step is to take the appropriate position — short for short hedges and long for long hedges — in
the futures market using a quantity of index futures that best replicates the portfolio (for short hedges) or the
anticipated addition to the portfolio (for long hedges).
Determining the quantity of index futures contracts that are needed in a hedge requires knowledge of a portfolio’s
beta. If the beta is not taken into consideration, the hedger may find that the portfolio is under-hedged in cases
where the actual beta is greater than 1, or over-hedged in cases where the actual beta is less than 1.
While the use of the beta to determine the number of contracts to use in a hedge cannot guarantee the elimination
of the risk of being under- or over-hedged, since beta only measures a historical relationship, it can give a portfolio
manager some level of assurance that potential losses will be minimized. The number of contracts a manager would
use to hedge a particular portfolio is calculated as follows:
PV (7.5)
H = bP ´
FCV

Where:
H = The number of contracts to use, also known as the hedge ratio
bP = The portfolio’s beta
PV = The dollar value of the portfolio to be hedged
FCV = The dollar value of one futures contract

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EXAMPLE
Hedging with Equity Index Futures
Suppose the manager of a $25 million portfolio of Canadian stocks has a bullish long-term outlook for the
Canadian market. However, the manager has concerns about the market outlook over the next three to six
months. Rather than going through the process of selling the portfolio now and then buying it back later, the
manager decides to retain the portfolio and use S&P/TSX 60 Index futures as a hedge. March S&P/TSX 60 Index
futures are trading at 400, and the multiplier for each contract is $200 multiplied by the futures price. Given the
portfolio has a beta of 1.2, the manager implements a short hedge by selling 375 futures contracts:

$25,000,000
1.2 ´ = 375 futures contracts
(400 ´ $200)
Three months later, the S&P/TSX 60 Index has declined by 10%. The manager now feels that the market has
bottomed and she wants to lift the hedge. If the futures declined by 11% to 356 and the portfolio’s stocks
behaved according to their historical betas, the portfolio’s overall profit or loss is calculated as follows:
Underlying portfolio: $25 million x 1.2 x (–10%) = $3 million loss
Futures position: (400 – 356) x 375 contracts x $200 = $3.3 million profit

In this case, the futures position offset all of the portfolio’s loss and more. This is because the futures price
declined more than the cash price.
If instead of falling, the S&P/TSX 60 Index had risen, the portfolio’s gains would have been offset to a large
extent by losses on the short futures position. In effect, the price that the manager paid for downside protection
was to forgo — for as long as the hedge was in place — most, if not all, of the portfolio’s unexpected gains.

There is no rule that requires a manager to hedge their entire portfolio. They can choose to hedge only a portion of
it. If so, the manager would calculate the hedge ratio using only the beta of the particular part of the portfolio to
be hedged. The same consideration should be made before implementing a partial long hedge. The manager should
estimate the average beta of the stocks that will be purchased and use this number when calculating the hedge
ratio.

CHANGING A PORTFOLIO’S ASSET MIX

The hedging illustration outlined in the previous section transformed the manager’s risky equity portfolio into a risk-
free portfolio that should earn a risk-free rate. The price of stock index futures is normally higher than a spot index.
A portion of this difference represents the interest that sellers forgo by selling futures, rather than selling the index
in the spot market and earning interest on the cash proceeds. The other portion, which actually lowers the price of
futures, represents the dividends from an index’s stocks that buyers forgo by buying futures instead of actual stocks.
However, what if the manager wants to transform their portfolio into 10-year Government of Canada bonds? Or
what if the manager wants to transform their portfolio into a portfolio of U.S. stocks? In this section, the following
two different methods for achieving these goals are discussed:
1. Stock index futures
2. Equity swaps

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PORTFOLIO ADJUSTMENTS USING STOCK INDEX FUTURES

Stock index futures allow portfolio managers to change a portfolio’s asset mix in a relatively easy and inexpensive
way. For example, if a manager of Canadian equities wants to lower their portfolio’s Canadian equity exposure and
add (or increase) exposure to the U.S. equity market — or any other foreign market with available equity index
futures — the manager simply has to sell a Canadian stock index futures contract and buy a U.S. stock index futures
contract.
To illustrate, suppose the manager in the previous example wants to temporarily shift their portfolio to an all-U.S.
equity portfolio. In addition to selling the Canadian index futures, the manager has to buy U.S. index futures. The
manager’s portfolio of Canadian stocks will be hedged by the short futures position and the resulting exposure will
be to the U.S. index underlying the U.S. futures contracts. Again, in addition to determining the desired beta of the
portfolio’s U.S. exposure, careful attention to the Canadian portfolio’s beta is required.
The manager could also gain exposure to any market with futures contracts, whether it is bonds, gold, corn or crude
oil. The bottom line is that portfolio managers do not need to sell their actual portfolio and buy the actual assets
where an exposure is desired. It can all be accomplished through futures contracts.

PORTFOLIO ADJUSTMENTS USING EQUITY SWAPS

In the late 1980s, Bankers Trust, a then-leader in financial innovation, started offering various risk management
products based on equity cash flows. The most popular product to emerge from its innovation was the equity
swap. In an equity swap, one counterparty receives cash flows that are based on an equity index, while the other
counterparty receives cash flows that are usually based on interest rates.
There are different variations to an equity swap. One variation is the creation of a synthetic equity position, which
allows a portfolio manager to earn equity returns without actually taking an equity position. Another variation is an
equity swap that allows a portfolio manager to transform equity returns into returns on other assets. An example of
each is outlined below.

EXAMPLE
Equity Swaps
Synthetic Equity Position

A portfolio manager with a $100 million fixed income portfolio has 20% of it, thus $20 million, invested in three-
month T-Bills. The portfolio manager would like to earn the S&P/TSX 60 Index’s return on the $20 million portion
of his portfolio, and would like to create a synthetic equity position by entering into an equity swap. The portfolio
manager agrees to pay a swap dealer the three-month T-Bill yield every three months based on a notional
amount of $20 million, and will receive the S&P/TSX 60 Index’s return over each three-month period. Only a net
payment representing the difference between these two payments is made between the two counterparties. As
a result, the portfolio manager is able to convert $20 million of his portfolio that is earning the T-Bill rate to an
equity investment that is earning the same rate of return as the S&P/TSX 60 Index.

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EXAMPLE
Equity Swaps – cont'd
Transforming Equity Returns

A portfolio manager with a $25 million Canadian equity portfolio wants to shift her portfolio entirely into
10-year Government of Canada bonds. Besides using Government of Canada bond futures, the manager enters
into an equity swap with a swap dealer. The equity swap is arranged so that the portfolio would make periodic
payments to the swap dealer based on the S&P/TSX 60 Index’s return. In turn, the swap dealer makes payments
to the portfolio based on the 10-year Government of Canada bond yield, which is currently 5.95%.
The portfolio’s beta is 1.2, so the manager enters into a swap with a principal amount of $30 million. If the portfolio’s
stocks behave as their beta suggests, its $25 million return will be equivalent to the return on a $30 million
investment in the S&P/TSX 60 index. The swap is structured so that payments will be made every six months.
After the first six months, the S&P/TSX 60 Index’s return was 6.5%. According to the above swap details, the
following payments will be made:
$1,950,000 from the portfolio to the swap dealer (6.5% of $30 million)
$892,500 from the swap dealer to the portfolio (2.975% of $30 million)

If the swap calls for net payments to be made between the two counterparties, the portfolio would pay the swap
dealer $1,057,500 [$1,950,000 – $892,500].

TAX CONSIDERATIONS
In practice, the tax treatment of the income a portfolio produces will determine the most appropriate type of
portfolio and portfolio management style for an investor or plan beneficiary based on their marginal tax rate,
investment horizon and investment income needs.
Non-taxable foundations created by tax-exempt institutions, such as religious organizations, or registered plans,
such as pension funds and RRSP-eligible mutual funds, allow realized income streams to compound within a plan
without being taxable in the hands of its beneficiary or contributor. Active management styles will realize capital
gains as individual security positions are liquidated and reinvested. When these realized gains are tax-exempt or
allowed to compound behind the tax shield, active management styles can add significant value to a portfolio.
Conversely, active management styles that realize taxable capital gains or taxable dividends or interest income may
not add value after taxes and transactions costs are considered.
In a taxable environment, investors will favour passively managed growth funds. Actively managed funds and those that
produce taxable income streams in the form of dividends and interest are a disadvantage in a taxable environment.
The effects of taxation must play a role in an investor’s choice of investments. Investment advisors must be aware
of these factors and advise clients accordingly. A portfolio manager needs to address these issues at a fund’s
inception when establishing its investment policy. A clear understanding of the fund’s clients will guide the manager
in choosing the most appropriate securities and management style.

THE USE OF EXCHANGE-TRADED FUNDS (ETFs) IN EQUITY

PORTFOLIO MANAGEMENT
ETFs are one of the fastest growing types of investment products. While they are often thought of as a retail
product, ETFs were first introduced for use within institutional markets. Institutional portfolio managers continue

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to be significant users of ETFs. In Canada, approximately 40% of the overall assets under management in ETFs are
associated with the institutional market, which includes pension funds, mutual funds, pooled funds, endowments
and institutional desks.15
These portfolio managers are using ETFs for many different reasons, as outlined in this section. As the ETF industry
continues to grow, it is expected that the use of ETFs by portfolio managers will increase. There are four industry
trends that are driving the next level of growth in ETFs, as follows:
• Growth in fee-based business
• Growth in advisors as portfolio managers
• Demand for transparency
• Broad choices and ongoing innovation in ETFs

The broadest use of ETFs by portfolio managers is for a smaller portion of an overall portfolio. In 2012, there were
over 1,000 mutual funds in the U.S. with ETFs listed as one of their holdings. There has been a growing trend of
portfolios that are mostly comprised of ETFs. In 2011, Morningstar started tracking portfolios in the U.S. with 50%
or more assets allocated to ETFs. In the first 12 months, the assets under management grew by 43%. In either
approach, ETFs are seen as tools with which portfolio managers can build more efficient portfolios.

DEFINITION OF ETFs
In Canada, an ETF is legally organized as a mutual fund trust. Similar to individual stocks, the units of the trust
are listed and traded on stock exchanges. An ETF holds an underlying basket of securities — equities, bonds,
commodities or derivatives — that tends to follow a preset list of securities. The S&P/TSX Composite Index is an
example of a preset list that ETFs follow.
This list is established and maintained by preset rules that set the criteria for the securities in this index. ETFs that
follow this approach are called passive investments, which represent the significant majority of listed ETFs.
The value of an ETF reflects the net asset value (NAV) of the underlying securities and trades based on the
portfolio’s weighted average bid-ask spread. Like stocks, ETFs can be bought on margin and sold short, and some
have options trading on them. Income generated by the securities in an ETF, such as dividends, interest or capital
gains, flows through to the investor so that it maintains its original characteristics.
With standard ETFs, the reference index can be exactly replicated, which is known as full replication, or
approximately constructed, which is a process known as sampling.
Full replication is often used with equity portfolios of large-capitalization stocks. In this case, the ETF holds all of the
stocks in the same weight as the respective index. As such, a full replication process will track extremely close to the
benchmark index (resulting in limited tracking error).
Sampling is the process where the portfolio manager selects securities and their weighting to best match an index’s
performance. While sampling is often used for fixed income, there are some cases when a full replication is not
optimal for equity ETFs. These cases reflect either considerations of liquidity or index construction. With index
construction, if the number of holdings within the index is significantly high, a sampling approach would make
the ETF more efficient given the costs to reproduce the full index. With a sampling approach, there could be some
differences between the index and the ETF’s performance. In most instances, the chance of a tracking error is small
but should be reviewed on a regular basis.

15
Investor Economics, 2010

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KEY FEATURES
From a portfolio manager’s perspective, ETFs have a number of key features.

TRANSPARENCY
For passive ETFs, all of their holdings are disclosed on a daily basis for investors and portfolio managers to see. This
disclosure provides the ETF’s composition and helps assess its attributes when adding it to a portfolio. Knowing an
ETF’s holdings helps a portfolio manager use them as building blocks to attain desired exposures, while mitigating
potential duplication with other holdings within the portfolio. For example, a manager that wants international
exposure can easily review an ETF’s holdings to see the specific stocks and their respective sectors, which will
identify potential overlaps with a current portfolio and help identify potential diversification benefits.
In addition to an ETF’s holdings being transparent, the rules that govern these holdings are also transparent. ETF
companies and index providers post this information on their respective websites. Based on this information, a
portfolio manager knows what to expect from the management of an ETF’s holdings in advance. For example,
the rebalancing rules and limits on specific securities or sectors are all outlined. Knowing the model for which the
holdings are determined provides the portfolio manager with a level of confidence.
Lastly, some ETF providers also post the tracking errors to their respective indexes. This also provides transparency,
as portfolio managers can see how the index has performed and how well the ETF has tracked it.

TARGETED EXPOSURE WITH DIVERSIFICATION

With the advancement of equity ETFs into sectors and regions, portfolio managers can now use them to implement
their investment themes where they once only used stocks. Given this refinement, ETFs can be thought of as tools
to create or supplement a portfolio to obtain an exposure, which can make top-down asset mix decisions easier to
implement. While ETFs provide targeted exposure, they still also offer diversification that mitigates single security
risk.

TAX EFFICIENCY
In regards to overall tax efficiency, ETFs provide two benefits, as follows:
• They tend to have low portfolio turnover, resulting in fewer realized capital gains than other investment
products.
• The open market trading of ETF units has no direct effect on the underlying portfolio and no tax consequences
on other unitholders. This is unlike mutual funds, where trading of a fund’s units might trigger capital gains if
enough investors redeem their shares all at once and force the manager to sell off securities to raise cash. ETFs
are similar to owning individual securities in that the trading activities of short-term holders will not have a
tax impact on long-term investors. ETF redemptions are typically placed by institutional holders and ETFs have
a process to allocate capital gains from those redemptions directly to the redeeming counterparty, instead of
affecting all unitholders.

LOWER COSTS
An ETF’s management costs are significantly lower than those of mutual funds. In some cases, the use of ETFs can
result in cost savings versus individual stocks. The following are two examples of potential cost savings from using
ETFs:

Transaction costs A portfolio manager has the choice to buy a few select individual securities or a pre-
defined basket of securities within an ETF. With the pre-defined basket, the manager will
only have one cost to buy or sell multiple securities at once. In addition, some ETFs have
automatic rebalancing, often with no cost to the portfolio.

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Reduced bid-offer For an ETF, the spread between the bid and offer can be even tighter than the weighted
spreads average bid-offer spread of its underlying constituents. While cost savings will be
more dramatic on less liquid assets, such as small-capitalization equities, the benefits
of supplementing an ETF for a portion of large-capitalization exposure can also be
beneficial.

LIQUIDITY
Like stocks, ETFs can be bought or sold throughout the trading day. It is important to outline that, unlike stocks, the
volume of trading is not a measurement of an ETF’s liquidity. An ETF’s true liquidity is an outcome of the liquidity
of its underlying securities. The fact that the liquidity of the underlying securities passes through to the ETF will be
explained in greater detail later in this chapter.
Liquidity is also a factor for how quickly a portfolio manager can implement their investment thesis. With ETFs,
a change in direction can be implemented with a limited number of transactions. This improves the speed in
which a directional move can be made and reduces the multiple individual stock transactions that are required to
implement a change.

ANALYSIS OF THE CHOICES TO ETFs

The development of ETFs has provided portfolio managers and their investors with another way to gain exposures
or provide cash equitization. The following is a review of three product choices with their advantages and
disadvantages.

Table 7.7 | Review of Three Product Choices with their Advantages and Disadvantages

ETFs Futures Swaps/Forwards

Advantages
• Liquidity • Low cost • Fees can be negotiable
• Exchange traded • Real-time pricing • Exposure is fully customizable
• Easily accessible • Easily accessible • No tracking error
• Accessible without derivatives • Leverage • Leverage
licensing
• Growing choice in products,
which permits targeted
exposures

Disadvantages
• Tracking error can be higher • Tracking error from contango/ • Counterparty risk
than the other two choices backwardation and rolling of • Lack of liquidity to exit the
• Fees can be higher than the contracts trade prior to expiration
other two choices • Inability to allocate to smaller • Lack of price discovery, as they
accounts are not traded on an exchange
• Liquidity issues on some • Inability to allocate to smaller
contracts and limited choice in accounts
desired exposure

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The increasing number of ETFs and the vastly different types of exposures they offer provide portfolio managers
with new options that can more precisely equitize a portfolio’s cash portion to effectively maintain their desired
exposures.

PORTFOLIO MANAGEMENT TECHNIQUES USING EQUITY ETFs

Over the years, the styles and types of portfolio management have changed. Initially, portfolio management was
provided in two different types of discretionary management, as follows:
• Through a pooled fund that the portfolio manager would be hired to run under a specific mandate. The
manager would develop and manage a model of holdings. All investors within the pool would receive the same
investment management.
• Through a separate account that an advisor would have discretion over. Each account would be different with
no centralized approach.

With the advent of technology, a centralized model can now manage securities within separate accounts. Through
this approach, managers can create several centralized mandates, such as income, growth and balanced. Each
mandate is comprised of a model portfolio of securities. Then, based on a client’s needs, an account is set up to
track the holdings of a respective model. This allows any changes to the centralized model to be reflected in a
client’s accounts. The process involves a bulk purchase or sale at the centralized level, then an allocation to the
client’s account. The holdings within the client’s account are tracked to confirm that they reflect the centralized
model. When a client’s account does not reflect the centralized model, the differences are flagged and an
explanation must be provided.
These changes to how investment management is provided combined with the arrival of ETFs, has created new
ways for portfolio managers to manage pools while supporting the growth of separately managed accounts. As
ETFs trade similar to stocks, they can be used in this bulk and allocation approach, and are effectively a new tool for
portfolio managers to consider.
Beyond being another investment tool, ETFs offer some key advantages within the investment management
process that are outlined in the next section.

LIQUIDITY MANAGEMENT
Portfolio managers often have a portion of their portfolios accessible to withdrawals or available from ongoing
contributions, which can create several issues for them, including the following:
• Not all of a portfolio’s securities may be liquid
• Uneven withdrawals or purchases across a portfolio can change its asset allocation
• It can force the purchase or sale of a single security at a sub-optimal time

Holding a portion of a portfolio in cash can cause a cash drag on its mandate.
For all types of portfolio managers, ETFs offer liquid investments that can provide a way to be fully invested in a
portfolio’s mandate. Thus, using ETFs can increase a portfolio’s liquidity without changing its asset mix. ETFs can
also be used as a small percentage of each asset class to provide greater liquidity. Then, when needed, transactions
can be conducted in the ETFs without impacting a portfolio’s core holdings. This will provide a minimal amount of
transactions to invest or withdraw funds and it would be done evenly across the portfolio.

TRANSITION MANAGEMENT
Transition management was one of the first areas in which portfolio managers used ETFs. In managing a portfolio’s
mandate, a specific security can be sold when a replacement has yet to be selected. To keep a portfolio invested in
the market and to reduce cash drag, a manager can use an ETF to maintain this exposure. In effect, the ETF becomes
a temporary holding spot and can be replaced once a new security is identified. This provides a specific targeted

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exposure with which to maintain a portfolio’s mandate, while providing a manager with the time to identify the
next outperforming security.
For institutional managers who use sub-advisors, ETFs can be used as a parking spot when transitioning from one
sub-advisor to another. During the selection process for an active manager as a sub-advisor, a passive investment in
an ETF can maintain the market exposure that is aligned with a portfolio’s benchmark.

CORE AND SATELLITE

Portfolio managers that focus on separately managed accounts often specialize in a specific market and manage
a core portfolio. They also recognize the need to supplement these core holdings to better diversify or make a
tactical call on the market. To meet this request, some portfolio managers use sub-advisors or mutual funds, but
liquidity and transparency are an issue with this approach. With the growing choices in ETFs, combined with their
transparency and liquidity, portfolio managers can consider them as an alternative low-cost diversification tool.
The broad choices and transparency of ETFs allow for the specific selection of a basket of securities that can work as
building blocks that work in concert with a manager’s holdings or asset allocation.
Institutional managers can use passive investments in ETFs as a low-cost way of accessing broad markets, then
focus on specialty areas to provide alpha to an overall portfolio.

SIMPLIFIED EXPOSURE TO PREVIOUSLY HARDER TO ACCESS ASSET CLASSES OR

STRATEGIES
As ETFs have expanded into offering hard to access asset classes, new levels of portfolio optimization can be
obtained. This is applicable to portfolio managers who manage pooled funds or separately managed accounts.
For example, gold was not easily purchased, stored or sold until the development of physical gold ETFs. Prior to
these ETFs, portfolio managers often used the equity position in a gold-producing company to indirectly provide
gold exposure. With gold ETFs, managers can now directly access this asset class at a low cost. In addition, there are
ETFs that offer other types of exposures, such as specific countries or emerging markets bonds, or strategies such as
covered calls. These ETFs are tools that have expanded the investment horizon, allowing portfolio managers to build
different types of portfolios that previously could not be created.

REBALANCING
Asset allocation is often considered the most important decision, and rebalancing is frequently a requirement for
a portfolio’s mandate. Rebalancing helps avoid drift and keeps portfolio risk within pre-defined limits. Having a
small allocation to domestic, international equity and fixed income ETFs provides an efficient way to rebalance
across asset classes when needed. The respective allocation to ETFs provides a simple and liquid way to rebalance
a portfolio’s asset allocation without impacting its core holdings. Using ETFs will also help lower the number of
transactions needed to rebalance a portfolio.

TACTICAL ASSET ALLOCATION

With the vast choice of available ETFs, portfolio managers can quickly gain diversified exposure to a targeted asset
class while instantly exiting a previous holding. Managers can use ETFs as a primary tool to implement tactical asset
allocation shifts or use them in combination with individual securities.
There are many approaches to conducting tactical asset allocation. In each case, these top-down investment
management approaches have been enhanced by the growing choice of ETFs. The following are just some of the
approaches to tactical asset allocation that ETFs can provide:
• Shifting between equities, cash, fixed income and commodities using broad market ETFs.
• Equity sector rotation using sector ETFs, such as utilities, industrials, energy and financials.

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• Changing between value and growth equities with value and growth ETFs, or even with low- and high-volatility
ETFs.
• Global positioning for equities and fixed income with ETFs that focus on emerging or developed markets, as well
as country-specific ETFs.

In each of these examples, ETFs have enabled portfolio managers to more efficiently implement a top-down
investment style.

MODEL CONSISTENCY
For portfolio managers who use a centralized model to administer separately managed accounts, ETFs can be used
to provide consistency in applying the investment model to all clients, regardless of an account’s size. This simplifies
the model’s administration while minimizing the dispersion in performance returns between them. The following are
some approaches where ETFs are used to provide consistency:

For small accounts ETFs can be used to mimic the asset mix of a larger account. Using a small number
of ETFs provides diversification while targeting desired sectors. As this can be done
with significantly fewer holdings, small accounts can participate in the same type of
investment management as large accounts.

For accounts that are ETFs can be short-term holding spots with similar market exposure until an account’s
accumulating assets assets are a reasonable enough size that they can be deployed efficiently into individual
stocks.

Employing a strategy ETFs allow all account sizes to access the strategy. When applied to large and small
such as a covered call accounts, it simplifies the model’s overall management.

TAX-LOSS SELLING
Separately managed accounts have the flexibility to execute the tax-loss selling of specific securities within a
portfolio on an individual account basis. Tax-loss selling is a strategy that harvests capital losses within a portfolio to
offset capital gains so as to reduce an investor’s overall tax bill. In harvesting the loss, it is assumed that the specific
position remains desirable and will be required once the loss is crystallized. To crystallize the loss, the position must
be exited for a minimum of 31 days, when the security or very similar investments cannot be repurchased within
that period.
ETFs are a way of maintaining a mandate’s desired exposure while executing the tax-loss selling strategy. In this
approach, a specific security with a capital loss position is exited for 31 days. Instead of holding cash over these 31
days and potentially missing positive market movements, an ETF can be used to maintain the necessary market
exposure. Moreover, as ETFs cover all asset classes and most sectors, the replacement ETF can be refined to further
limit the opportunity cost of executing this strategy.

HEDGING
Often, portfolio managers want to hedge anticipated market movements. The broad choice of ETFs allows them to
consider them as a tool to hedge a portfolio.
Pooled fund managers can neutralize a good portion of a portfolio by entering a short trade in an ETF. This is an
alternative to selling securities within a portfolio, thereby avoiding capital gains and transaction costs. Alternatively,
pooled fund managers may want to take out the market movements relative to a specific security by shorting a
sector ETF and going long the specific security.
A challenge for separately managed accounts is that they tend not to permit short positions. A single inverse ETF
can be used to provide similar exposure. Hedging currency movements is also an issue for separately managed

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7 • 38 PORTFOLIO MANAGEMENT TECHNIQUES

accounts, as it is challenging to allocate the derivative to the account level. Some ETFs offer currency hedged
exposure to international markets, which provides an effective tool to enter a basket of international holdings that
are also hedged for currency movements. This all-in-one solution can be allocated to the respective accounts.

CONSIDERATIONS WHEN INVESTING IN ETFs

This section is based on discussions with portfolio managers who are using ETFs. In developing this section, we
wanted to know their key considerations when selecting an ETF. This section provides an understanding of these key
considerations and provides further insights into trading ETFs.

AN ETF’S LIQUIDITY
One of the most misunderstood aspects of an ETF is liquidity and volume traded.
The volume traded of an ETF does not demonstrate liquidity, as it does for a stock. With ETFs, the buyer and seller
use an exchange, which is similar to purchasing stocks or closed-end funds in the open market. One key difference
between ETFs and stocks or closed-end funds is that they are open-ended, meaning that supply and demand do not
drive price.
The expanded role of the market maker for an ETF is a key part of this feature. The market maker supports the
liquidity of stocks and ETFs. However, with ETFs, the market maker can also provide a secondary level of liquidity by
exchanging a basket of holdings with the ETF companies for ETF units — and vice versa. This allows for the creation
and removal of ETF units within the market. This process is the key way in which an ETF will reflect the NAV of the
underlying basket of securities and trade throughout the day.
As an ETF is simply a basket of securities, if the underlying is liquid then so is the ETF. Since the basket of securities
is exchangeable for the ETF’s units, any differences are an arbitrage opportunity for market makers and are simply
traded away. In this way, the bid-offer spread of the underlying will transfer through to the ETF. As the bid-offer
spread transfers through, looking at the spread is a way to look at an ETF’s liquidity. Generally, ETFs with larger
bid-offer spreads represent less liquid baskets. It is important when looking at the bid-offer spread to look at level II
quotes. With level II quotes, you see beyond the retail level of trading of a few thousand shares, seeing the spread to
move a block of 10,000 shares or more will show the ETF’s true liquidity. Wider spreads should be expected for ETFs
with small-capitalization stocks and international holdings, as they represent less liquid baskets. While the spread
will show an ETF’s liquidity, it is also another cost to investing in an ETF, and needs to be managed like all other
costs. In some cases, managers can look at the difference between the current market price and the NAV as another
way to look at an ETF’s liquidity.
ETFs that trade in the U.S. are required to post a real-time view of the NAV known as the indicative net asset value
(iNAV). In Canada, some ETF companies will provide the iNAV as a special service to portfolio managers as an
indication of where they should place their bid or offer to get their trade filled.
What follows are some simple tips when placing trades in an ETF:
• Use limit orders, which is especially important when placing large trades.
• There is limited advantage to showing small portions at a time of a large trade (working a trade). Unlike stocks
where a trade can be worked, with an ETF, if there is a large trade, it is beneficial to place large portions of it at
once so that the market maker knows they will need to create new ETF units to meet this demand.
• Avoid trading during the first and last 15 minutes of the trading day, as studies show there is less liquidity at
those times.

AN ETF’S TRACKING ERROR

An ETF’s tracking error measures its performance relative to its index. When there is full replication of the index,
the tracking error should simply be the fees. In cases where the manager is sampling the holdings to represent
the index, the tracking error could be larger. Beyond sampling, there are reasons why an ETF could have a tracking

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7 • 39

error, including trading costs, hedging costs and cash drag. If a manager is looking to attain a specific exposure, it is
important for them to review an ETF’s tracking error to see the dispersion in performance. ETFs with lower tracking
errors will better represent the desired exposure. Some ETF companies post tracking errors on their websites.

FUND COMPANY, MANAGEMENT AND SERVICING

Like all fund companies, there is a level of due diligence required when investing in a product. This is still a
consideration when investing in ETFs on a long–term basis. Does management have the skills and expertise to
manage the existing offering or to create new products? Past tracking errors are a reflection of a manager’s skills.
When launching a new product, have they taken the necessary steps to factor in the liquidity of the underlying and
past demand for the product? Are they taking the time to analyze the market before launching a new product? Have
they regularly closed ETFs? Do they engage in securities lending and how much of the book is lent out? How is the
servicing on their products? What is their level of transparency? How often is their website updated? These are just
some of the things to consider when looking at the management and servicing of ETFs.

EXPANDING CHOICES WITH ETFs

Since the creation of an ETF based on the Toronto Stock Exchange in 1990, the industry has expanded in many ways.
While initially, ETFs tracked broad markets like the S&P 500 Index, they have advanced in several aspects to be used
as tools to attain new types of exposures and provide ways to build a portfolio that were simply not available only a
few years ago. Some examples of this innovation are discussed below.

SEGMENTATION OF THE BROAD MARKET INTO SECTORS

With the growing number of ETFs that segment the market, they can now be used to target exposures. For example,
investors who do not want to invest in the broader market or want to increase their holdings in a specific sector can
select ETFs that focus on just one sector of the market. In some cases, segmentation is further refined to a specific
industry.

DIFFERENT APPROACHES TO WEIGHT THE HOLDINGS

ETFs initially followed an approach that weighted the holdings based on their market capitalization, but the industry
has expanded and now provides many different weighting approaches to better represent the exposures that
advisors and investors are looking for. For example, equal or factor weighting approaches will each offer different
attributes. With equal weighting, diversification is set equally for all holdings, while factor weighting identifies a
specific factor, such as dividend yield or beta, to set the weighting.

COUNTRY-BASED ETFs
Many advisors find it difficult to access specific countries to provide their clients with greater diversification or to
implement a tactical investment into a specific region. ETF providers have worked to fill this gap by offering region-
and country-based offerings on a low-cost basis.

STRATEGY-BASED ETFs
Many advisors and clients are looking for a specific strategy to be executed through an ETF. An early example would
be dividend-focused ETFs, and recent examples include covered call and low-volatility ETFs. With these types of
ETFs, the focus is on gaining exposure to a specific theme.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe the bottom-up and top-down approaches to equity portfolio management.
Bottom-up approach: The portfolio manager begins by seeking out individual securities to include in a
portfolio. It can take the form of either a value- or growth-oriented approach.
Top-down approach: Begins with a macro- or microeconomic analysis of trends and market forecasts in the
global, North American and Canadian economies. A portfolio manager selects the sectors they expect will
outperform other sectors within the expected economic outlook.
2. Differentiate between the value-oriented and growth-oriented approaches to investing.
Value-oriented: Looks for undervalued securities, with little focus on overall economic and market
conditions.
Growth-oriented: Focuses on individual securities with superior earnings growth rates relative to the market
in general.
3. Describe the passive style of equity portfolio management and discuss the three techniques normally used to
construct an index fund.
Passive portfolio management is consistent with the view that securities markets are efficient — that is,
securities prices always reflect all relevant information concerning expected return and risk.
The three approaches to constructing an index fund are replicating an index, tracking an index and
fundamental indexing:
« Replicating an index: Select an appropriate index to replicate, then hold each stock within the fund’s
portfolio in exact proportion to its weighting within the index.
« Tracking an index: A portfolio manager constructs a subset of the benchmark that faithfully mimics an
index. Sampling and mathematical models are two different methods that managers use in index tracking.
« Fundamental indexing: Each stock’s index weighting is determined by four fundamental measures: trailing
five-year cash flow, trailing five-year sales, trailing five-year gross dividends and book value.
4. Explain how to use the risk budgeting process to build a portfolio.
Risk budgeting is a common technique used to create an enhanced index portfolio.
There are four steps in the risk budgeting process:
« Determining the appropriate benchmark for a portfolio.
« Determining the maximum acceptable tracking error for a portfolio.
« Identifying the tactical asset allocation or specific return opportunities among securities.
« Building a portfolio that deviates from the benchmark using the return opportunities identified without
exceeding the tracking error limit.
5. Describe the active style of equity portfolio management, including enhanced active equity investing,
long–short investing and portable alpha strategies.
An active portfolio manager acts as if they can identify underpriced securities, known as the selection
dimension, and can also anticipate general market movements, known as the timing dimension.
Enhanced active equity investing: An active manager overweights the securities they expect will outperform
the benchmark, and underweights those they expect will underperform the benchmark.

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 CHAPTER 7 | MANAGING EQUITY PORTFOLIOS 7 • 41

Market-neutral long–short investing: This is a portfolio construction technique designed to take greater
advantage of information within equity markets. The difference between market-neutral management and
more traditional active management is that market-neutral management eliminates the market’s effect and
is more aggressive in its stock shorting, amplifying the approach by using leverage.
Portable alpha: This is the process of using derivatives or short selling to separate the alpha and beta return
decisions, and apply the alpha to portfolios of other asset classes.
6. Explain how derivatives can be used to reduce an equity portfolio’s systematic risk.
Reducing a portfolio’s systematic risk involves the implementation of a short hedge, which is implemented
by selling equity index futures.

7. Aside from hedging, demonstrate the ways in which derivatives can be used in equity portfolio management.
Derivatives can be used to change a portfolio’s asset mix. Methods to accomplish this include portfolio
adjustments using stock index futures or equity swaps.

8. Discuss the taxation considerations of various equity portfolio management styles.

When realized gains are tax-exempt or allowed to compound behind the tax shield, active management
styles can add significant value to a portfolio.
In a taxable environment, investors will favour passively managed growth funds.
9. Describe exchange-traded funds (ETFs) and discuss the ways in which they can be used in equity portfolio
management.
An ETF holds an underlying basket of securities (equities, bonds, commodities or derivatives), which tends to
follow a preset list of securities.
Exchange-traded fund (ETF) units are listed and traded on a stock exchange.
ETFs are used by portfolio managers for many different reasons, such as liquidity management, transition
management, to supplement core holdings, simplifying exposure to previously harder to-access asset classes
or strategies, rebalancing, tactical asset allocation, model consistency, tax-loss selling, and hedging.

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 Managing Fixed Income
Portfolios 8

CONTENT AREAS

Fixed Income Trading Operations

Bond Management Styles

Box Trades

Other Bond Portfolio Construction Techniques

High-Yield (Junk) Bonds

Fixed Income Exchange-Traded Funds (ETFs)

LEARNING OBJECTIVES

1 | Describe the roles and responsibilities of a fixed income portfolio manager and trader.

2 | Describe a repurchase agreement (repo) transaction.

3 | Compare buy-side and sell-side fixed income professionals.

4 | Compare passive and active bond management styles, particularly how their approach to interest
rate risk differs.

5 | Discuss and describe the properties of duration in portfolio management and, given all of the inputs,
calculate the Macaulay duration and modified duration of a bond and bond portfolio.

6 | Describe the main strategies associated with a passive bond management style, including buy and
hold, using barbell and laddered portfolios and creating a bond index fund.

7 | Describe the process of target date immunization and contingent immunization.

8 | Describe the primary active portfolio management strategies, including interest rate anticipation and
box trades.

9 | Discuss the structure of mortgage-backed securities (MBS), asset-backed securities (ABS),

collateralized debt obligations, foreign currency instruments and real return bonds.

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8•2 PORTFOLIO MANAGEMENT TECHNIQUES

LEARNING OBJECTIVES

10 | Demonstrate the ways derivatives can be used in fixed income portfolio management.

11 | Discuss high-yield bonds.

12 | Describe fixed income exchange-traded funds (ETFs).

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

active bond management credit derivatives passive bond management

asset-backed securities foreign-denominated bonds rate anticipation swap

(ABS)
forward rate agreement real return bonds
barbell portfolio (FRA)
recovery rate
basis risk hedge ratio
repo transaction
bond swap horizon analysis
securitization
box trade immunization
special purpose vehicle
buy-and-hold strategy interest rate futures (SPV)

cash collateralized debt interest rate risk step-up bond

obligation
interest rate swap synthetic collateralized
cellular (stratified) debt obligation
sampling laddered portfolio
target date immunization
collateralized debt Macaulay duration
obligation (CDO) tracking error minimization
Macaulay duration formula
contingent immunization tranches
mortgage-backed securities
credit default swap (CDS) (MBS)

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8•3

INTRODUCTION
As is the case with equities, bond portfolio management strategies can be passive or active. However, fixed income
portfolio management goes far beyond these two management styles. It includes more sophisticated instruments
that, similar to bonds, have relatively determined payments, as well as the risk management products that portfolio
managers can use to control bond portfolio volatility.
The value of a bond portfolio, which comprises a variety of bonds of different maturities and from numerous
issuers, depends critically on the yield curve. A bond portfolio’s management involves selecting different bond
issues and maturities — a process that entails replacing maturing bonds and purchasing additional ones with new
funds. Managing the portfolio may also require the sale of bonds if funds are required or as a strategic response to
perceived changes in the yield curve. A more active management style involves making changes to a portfolio in
response to economic forecasts and their predicted effects on the yield curve and spreads between government and
lower-grade bonds.
This chapter begins with a look at an institutional investment management firm’s fixed income trading operations.
Then there is a discussion of passive bond portfolio management strategies, including traditional portfolio design
and indexed portfolios, as well as immunizing a portfolio against interest rate changes and anticipated cash
flow requirements. We then turn to a discussion about active portfolio management techniques that are used
in anticipation of interest rate changes and for profiting from the differences in yield spreads. Next is a look at
alternative instruments, including mortgage- and asset-backed securities, and collateralized debt obligations. The
chapter concludes with a discussion of the use of derivatives in fixed income portfolio management.

FIXED INCOME TRADING OPERATIONS

ROLES AND RESPONSIBILITIES

Most medium- to large-sized institutional investment management firms divide fixed income portfolio
management duties into two primary occupational roles: portfolio manager and trader. This division of duties does
not normally exist for small institutional investment management firms, where the fixed income portfolio manager
performs both roles.
In this section, we look at the typical responsibilities for these two fixed income portfolio management roles.

PORTFOLIO MANAGER
The role of a fixed income portfolio manager normally involves the following major responsibilities:
• Creating the investment mandate, investment goals and investment guidelines/restrictions for each fixed
income portfolio.
• Developing and executing each fixed income portfolio’s strategy.
• Providing pertinent and timely information to the head of fixed income markets.
• Supervising all fixed income portfolio management staff, including traders, assistant portfolio managers and any
associated administrative personnel.
• Providing information to assist a firm’s marketing and client service personnel, including:
The outlook for fixed income markets and the positioning of the fixed income portfolios relative to this market
outlook.
The explanation of a fixed income portfolio’s periodic performance, including a detailed performance
attribution analysis that explains its various sources of relative performance versus its specific performance
benchmark index.

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8•4 PORTFOLIO MANAGEMENT TECHNIQUES

• Representing the firm at new client marketing meetings, client service meetings, industry conferences and
interviews with the financial press, as required.

In essence, the portfolio manager is responsible for all aspects of a fixed income portfolio’s effective and compliant
management, and is therefore ultimately responsible for its performance.

TRADER
A fixed income trader has a narrower range of responsibilities, as compared to a fixed income portfolio manager.
Nevertheless, a trader’s potential contribution to a portfolio’s performance is still of consequence. A fixed income
trader’s major responsibilities include the following:
• Providing the most effective execution of a portfolio manager’s desired trades.
• Remaining informed at all times of a portfolio manager’s detailed investment strategy.
• Keeping a portfolio manager apprised of the bond market’s conditions and trends, and informing them as to
how these market conditions can affect the portfolio manager’s investment strategy.
• Maintaining a good professional relationships with the fixed income sales and trading staff from brokers/dealers
the firm does business with.

A fixed income trader’s primary goal is to execute a portfolio manager’s trades at the best prices at the time of
trade. Best execution contributes favourably to the fixed income portfolio’s performance, since it involves obtaining
the best available prices in the market when securities are traded. A trader accomplishes this task by keeping in
constant contact with their counterparties at the broker/dealers in order to have a good understanding of both the
overall bond market conditions and the liquidity of the sectors and securities a portfolio manager is most involved
in. As such, a trader often serves as a portfolio manager’s “ear to the market”.

FIXED INCOME DEPARTMENT – FUNCTIONAL ORGANIZATION

The diagram below shows the typical functional organization of a fixed income portfolio management department
at a medium- to large-sized institutional investment management firm.

Diagram 8.1 | Typical Functional Organization of a Fixed Income Department

Chief Investment
Officer

Head Head
Fixed-income Equities

Portfolio Manager Portfolio Manager Portfolio Manager

Domestic Fixed-income Foreign Fixed-income High Yield Fixed-income

Trader Assistant Portfolio Manager Assistant Portfolio Manager

Domestic Fixed-income Domestic Fixed-income Domestic Fixed-income

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8•5

The reporting line of authority is highlighted for the domestic fixed income portion of a firm’s assets under
management (AUM). Similar lines of authority normally exist for other major fixed-income sectors, such as foreign
fixed-income and high-yield fixed income.
Within a firm, the portfolio manager who is responsible for all domestic fixed income portfolio management
normally reports to the global head of fixed income portfolio management, who in turn reports to the chief
investment officer. The assistant portfolio managers and trader(s) who are responsible for domestic fixed income
portfolios report directly to the portfolio manager who is responsible for domestic fixed income. Under this typical
organizational structure, the portfolio manager is also ultimately responsible for the activities and effectiveness of
the fixed income portfolio trader(s) they supervise.

RELATIONSHIP BETWEEN A PORTFOLIO MANAGER AND TRADER

A fixed income portfolio manager and trader must work very closely together as a team in order to maximize the
overall effectiveness of their combined portfolio management duties and responsibilities. It is generally accepted —
and indeed often the case — that portfolio managers and traders have different skills and capabilities. However, the
effective combination of these skills and capabilities is key to maximizing the results for the portfolios they manage.
In order for the portfolio manager-trader relationship to be most effective, each individual must recognize the skills
and strengths of the other and strive to make decisions based on them.
Open and clear communication between the two individuals is also necessary for an effective working relationship.
Communication failures can potentially have drastic results for the portfolios under management and the
individuals themselves.
A fixed income portfolio manager’s primary focus is economic analysis, monetary policy and the creation of an
overall fixed income portfolio strategy, while a trader is focused on transaction execution. Strong capabilities in both
of these areas are required to excel in the highly competitive area of institutional portfolio management.

BOND FINANCING AND REPO TRANSACTIONS

Some institutional fixed income investment managers can invest their clients’ funds on a long-only basis and
therefore cannot incorporate other portfolio management techniques, such as leverage and short selling. This
limitation would normally apply to the following types of institutional investment managers:
• Pension plans and endowments
• Life insurance and property/casualty companies
• Institutional investment managers offering pooled funds to high-net-worth and institutional investors

However, there are certain types of institutional investment managers and traders that can — and generally do —
incorporate leverage and/or short-selling techniques in their portfolio and trading activities. The primary types are
as follows:
• Traders/market makers at broker/dealers
• Proprietary traders at broker/dealers
• Hedge fund managers

Traders and market makers at broker/dealers normally leverage (finance) their fixed income portfolios by using
repo transactions. A standard repo transaction is essentially a sale/repurchase agreement wherein a broker/dealer
does the following:
• Sells a fixed income security to a third party, usually an institutional investor, on a specific day at an agreed
upon price; and

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8•6 PORTFOLIO MANAGEMENT TECHNIQUES

• Simultaneously agrees to buy back (repurchase) the same security from the institutional investor at a set price
on a future date, which is usually one day later; although, some repo transactions can be for as long as a week.
The difference between the repurchase price and the sale price for the fixed income security is essentially the
borrowing (or financing) cost for the broker/dealer. The dealer then uses these borrowed funds to purchase other
fixed income securities for trading purposes, and accordingly leverages the size of its fixed income portfolio. Of
course, this financing cost is normally deducted from a portfolio manager’s trading performance, and therefore
represents an additional financial hurdle that they must consider when deciding to enter into trades that require
financing.

COMPARISON OF SELL-SIDE AND BUY-SIDE FIXED INCOME

PROFESSIONALS
Due to the over-the-counter (OTC) nature of fixed income markets, institutional fixed income portfolio managers
(buy side) and fixed income traders at broker/dealers (sell side) are normally on the opposite side of a transaction.
Although they are both trading the same security and trying to profit from the transaction, there are a number
of essential differences between the nature, goals and both internal and regulatory limitations placed on each of
these fixed income market participants, respectively. Table 8.1 highlights the primary differences between these two
professionals:

Table 8.1 | Sell-Side Versus Buy-Side Fixed Income Professionals

Comparison Fixed Income Trader Institutional Fixed Income

Aspect at a Broker/Dealer Portfolio Manager

Primary occupational Absolute performance: Earn the Relative performance: Rank as high as possible
goal/performance highest amount of capital gains and in appropriate peer performance analysis.
factor return on capital from fixed income High relative portfolio performance ranking
trading operations. is viewed as critical and essential in order for
the firm to grow its AUM, thereby increasing
its revenue through higher investment
management fees.
(Note: An absolute performance goal is shared
by fixed income hedge fund managers.)

Secondary Increase the market share of trading Contribute to the growth of the firm’s AUM by
occupational goal/ activity with institutional investor supporting sales/marketing efforts and client
performance factor target market. service activities.

Tertiary occupational Assist with the growth and Contribute to a firm’s growth through the
goal/performance profitability of the firm’s fixed income support of new product design and launches.
factor underwriting operations by providing
counsel regarding market conditions
and new issue pricing.

Source of assets Broker/dealer capital Investor funds (both individual and

institutional)

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8•7

Table 8.1 | Sell-Side Versus Buy-Side Fixed Income Professionals

Comparison Fixed Income Trader Institutional Fixed Income

Aspect at a Broker/Dealer Portfolio Manager
Regulatory capital Yes, broker/dealer must operate None
charges and within the regulatory restrictions
limitations that govern the firm’s capital
management.

Use of leverage Yes, with amount varying almost Not permitted, except for most fixed income
constantly, but within regulatory hedge funds.
limits. Required in order to
underwrite fixed income securities
and make two-way markets.

Use of short sales Yes, in fact it is required by those Not permitted, except for mutual funds and
broker/dealers who are required to most fixed income hedge funds.
make constant two-way markets for
government fixed income securities.

Immediate Head of domestic fixed income Head of fixed income

supervisor trading

Direct staff reports Usually none. In some cases, perhaps Assistant portfolio manager(s), fixed income
a fixed income trading assistant. trader(s) and some administrative staff

Range of securities Normally responsible for trading/ Usually responsible for a very broad
managed/traded market making for a very narrow range of fixed income issuers — federal/
range of securities. Example: Only provincial governments, corporate issuers
Government of Canada bonds and securitized products — since most fixed
maturing within a one- to five-year income fund mandates relate to broad fixed
period. income market indexes. The range will be
narrowed accordingly for specialized fixed
income funds, such as government-only funds
or high-yield funds.

Individual First level: Salary First level: Salary

compensation
Second level: Annual bonus, primarily Second level: Annual bonus, primarily cash,
cash, based on a pre-defined portion mainly based on the quartile ranking of
of a portfolio’s pre-tax trading gains portfolios in peer performance surveys for the
for the prior year, which is also known prior year.
as direct drive. In addition, a portion
Third level: Stock options and/or restricted
of the annual cash bonus can be
shares.
based on the pre-tax trading gains of
the broader fixed income trading unit (Note: Variable compensation potential
or department. is typically higher for portfolio managers
at hedge funds, but it is based on a pre-
Third level: Stock options, restricted
determined percentage of a fund’s absolute
shares and/or share of the firm’s
performance for the prior year.)
overall profitability.

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8•8 PORTFOLIO MANAGEMENT TECHNIQUES

BOND MANAGEMENT STYLES

Conventionally, bonds are viewed as very conservative instruments that are relatively simple to manage. This is
correct if one limits a bond’s management to a buy-and-hold strategy involving government or other investment-
grade bonds. However, this conservative strategy raises the question of whether to go long or short in maturity.
With a normal (rising) yield curve (see Figure 8.1), long maturities will have higher yields and be more attractive.
Although buy-and-hold guarantees the principal, if interest rates were to rise, it would actually be more profitable
to reinvest in the short term. Similarly, if interest rates were to fall, it would be better to invest long and sell
before maturity, thereby gaining on the bond’s value. With this aim of exceeding the fair rate of return by judicious
maturity selection, the seeds of active management are planted.

Figure 8.1 | The Yield Curve

Legend:
Inverted Yield
Yield to Maturity (%)

15%
Normal Yield Curve

10%

5%

0%
0 1 2 3 4 5 10 20
Years to Maturity

As with equity portfolio management, bond portfolio management techniques are formally segregated into passive
and active styles. These terms refer to a portfolio manager’s investment motivations, rather than the degree of
action required. Passive bond management minimizes the effects of interest rate risk on a bond portfolio. With
this style, no attempt is made to predict the direction or magnitude of interest rates. On the other hand, active
bond management attempts to profit from interest rate risk by predicting the direction or magnitude of rate
changes.
Once a portfolio manager decides to engage in active management, the conservative view of bonds no longer
applies. In fact, active management is far more sophisticated and can expose a portfolio manager to even higher
risks than those of passively managed stock portfolios. Anticipating changes in interest rates and the size of spreads
between high- and low-grade corporate bonds can lead to a variety of strategies that are designed to profit from
these changes. To understand how changes in interest rates can lead to changes in bond prices and portfolio values,
it is necessary to first examine the concept of duration and the risks associated with interest rate changes.

INTEREST RATE SENSITIVITY

Interest rate risk, which is the variation in bond values due to changes in market yields, affects investors in two
ways. First, there is the well-known price risk, which is the variation in market value, and second, the reinvestment
rate risk, which is the chance that future proceeds will be reinvested at a lower future interest rate.
The first step in choosing between passive and active management is to examine the sensitivity of bond values to
interest rate changes. Besides the inverse relationship that exists between a bond’s value and market rates (interest

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8•9

rates), the factors that affect the price response to interest rate changes are the coupon paid and the bond’s
maturity.

EXAMPLE
Price Sensitivity
Consider three different maturities — one, 15 and 30 years — for two different bonds with a face value of $1,000:
one is a semi-annual pay 8% coupon bond and the other is a zero-coupon bond with semi-annual compounding.
Table 8.2 shows the prices for each bond for annual yields of 6% and 7%, as well as the change in value that
occurs as the yields rise from 6% to 7%, expressed as a percentage of the value at 6%.

Table 8.2 | Price Sensitivity of 8% and Zero-Coupon Bonds ($1,000 Face Value)

Market Rate One Year 15 Years 30 Years

8% Coupon Bond
6% 1,019.13 1,196.00 1276.76
7% 1,009.50 1,091.96 1124.72
Price Change –9.63 –104.04 –152.04
As % of Value –0.94% –8.70% –11.91%
Zero-Coupon Bond
6% 942.60 411.99 169.73
7% 933.51 356.28 126.93
Price Change –9.09 –55.71 –42.80
As % of Value –0.96% –13.52% –25.22%

The coupon bond is selling at a premium due to its high coupon rate. The bond’s price is based on the formula
(Equation 8.1) for the valuation of an n-year bond with a face value (FV), an annual coupon rate of C (expressed
as a decimal), an annual yield to maturity of y (expressed as a decimal) and k coupon payments per year; for
example, k = 1 for annual pay bonds, k = 2 for semi-annual pay bonds and so on.
n´k
FV ´ C ¸ k FV (8.1)
P = å (1 + ( y k ))
t =1
t
+ n´k
(1 + ( y k ))

Alternatively, there is a simpler formula (Equation 8.2). The variables in the formula are the same as the ones
shown above. The first term calculates the present value of all the coupon payments in one formula, where
C equals the coupon’s dollar value. The second term calculates the present value of the bond’s face value, as
follows:

é 1 ù (8.2)
ê1 - ú
ê n´k ú é ù
ê (1 + ( y k )) ú ê FV ú
P = C´ê ú+ê ú
y k ê n´k ú
ú êë (1 + ( y k )) úû
ê ú
ê
ê ú
ëê ûú

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8 • 10 PORTFOLIO MANAGEMENT TECHNIQUES

EXAMPLE
Price Sensitivity – cont'd
For a zero-coupon bond, the price is determined using only the last term in either of the above formulas, because
there are no coupon payments (C = 0).
Two patterns of price sensitivity are evident from the information in Table 8.2:
1. All else being equal, the longer the bond’s maturity, the higher its sensitivity to changes in interest rates.
2. All else being equal, the lower the bond’s coupon rate, the higher its sensitivity to changes in interest rates.

One way to understand price sensitivity is to recognize that a coupon bond, with payments at each semi-annual
period, is a more complex instrument than a zero-coupon bond. The earlier payment of interest helps to partly
shield it from the long-run effects of interest rate changes. In the next section, we will see how the concept of
duration is used to measure a bond’s sensitivity to interest rate changes.

MACAULAY DURATION
A zero-coupon bond is a discount instrument like a Treasury Bill (T-bill), which makes a single payment at its
maturity. Consequently, it has a yield to maturity based on its current price and its maturity value. However, a
regular coupon bond is a complicated instrument that makes a series of payments over its life. The true value of a
20-year semi-annual coupon bond is not actually its series of interest payments and the principal discounted at
the stated yield for 20-year bonds. Instead, it is the sum of 40 semi-annual payments, each discounted at the rate
pertaining to it from the current yield curve for that grade of bond. Because of its payment pattern, a zero-coupon’s
maturity accurately represents its effective maturity. But, if weight is given to a coupon bond’s early interest
payments, its dollar-weighted effective maturity is shorter than its actual maturity. In 1938, to deal with the
valuation and time pattern, Frederick Macaulay devised a formula to calculate duration that is now known as the
Macaulay duration formula, or more specifically the Macaulay duration.1
The formula for calculating the Macaulay duration of a coupon bond is shown in Equation 8.3, as follows:
n´k
CFt 1 (8.3)
Macaulay Duration = å(t k ) ´ (1 + ( y k ))
t =1
t
´
P

EXAMPLE
Calculating a Bond’s Duration Using the Macaulay Duration
Table 8.3 shows the calculation of duration using the Macaulay duration (see Equation 8.3) for two bonds
with a $1,000 face value: a four-year, 8% semi-annual pay bond and a four-year zero-coupon bond. Each has a
6% annual yield to maturity. The weights in column 4 are unitless, being column 3 dollars divided by the sum
of column 3. The values in column 5 are units of time, which are expressed as years. As indicated previously,
the zero-coupon bond has the same duration of four years as its maturity. However, the coupon bond has a
significantly shorter duration of 3.52 years.

1
Frederick Macaulay, The Movements of Interest Rates, Bond Yields, and Stock Prices in the United States Since 1856 (New York: National Bureau
of Economic Research, 1938).

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8 • 11

EXAMPLE
Calculating a Bond’s Duration Using Macaulay Duration – cont'd

Table 8.3 | Duration Calculation for Coupon and Zero-Coupon Bonds ($1,000 Face Value)

1 2 3 4 5
Time in Years Cash Flow Present Value of Weight Column 1 ×
of Payment Payment Column 4
8% Coupon 0.5 40 38.835 0.036 0.018
1.0 40 37.704 0.035 0.035
1.5 40 36.606 0.034 0.051
2.0 40 35.539 0.033 0.066
2.5 40 34.504 0.032 0.081
3.0 40 33.499 0.031 0.094
3.5 40 32.524 0.030 0.106
4.0 1,040 820.986 0.767 3.069
Coupon Bond Total = 1070.197 1.000 3.52

Zero-Coupon 0.5–3.5 0 0.000 0.000 0.000

Bond
4.0 1,000 789.409 1.000 4.000
Zero-Coupon Bond Total = 789.409 1.000 4.000

To understand how the Macaulay duration (see Equation 8.3) operates, let us work through the calculation for the
fourth cash flow, which occurs at the end of the bond’s second year of life.
Since it is the fourth cash flow, t = 4, and because the bond pays interest semi-annually, t/k = 2. This is the value in
the first column, which represents the time in years of payment, and the first term in Equation 8.3.
The actual cash flow — CFt, at t = 4 — is $40, which is calculated as $1,000 × (0.08 ÷ 2). This is the numerator
of the second term in Equation 8.3. Given an annual yield of 6%, the denominator is equal to (1.03)4 or 1.1255.
Dividing $40 by 1.1255 equals $35.539, which is the present value of the fourth coupon payment. This is the value
in the third column of the table.
The last term in Equation 8.3 is the inverse of the bond price, or 0.0009344, given a bond price of $1,070.197.
Equation 8.3 requires us to multiply the three terms together for cash flow, and then sum them up to arrive at
the bond’s duration. The fourth column in the table is the product of the second and third terms. For t = 4, this is
$35.539 × 0.0009344, or 0.033. Finally, 0.033 is multiplied by 2, which is the corresponding number in column 1,
to get 0.066, which is the value in column 5.
Because the contribution to the overall duration for each cash flow period includes several calculations, it is
advisable to use a table format, similar to Table 8.3, to keep track of all the different steps.

Duration is an extremely useful concept with three applications. First, its primary use is to describe the effective
maturity of a bond and bond portfolio. The actual maturity of a bond portfolio would be that of its longest bond,
which is clearly an almost irrelevant statistic considering what proportion of funds is invested in that bond. Second,
duration measures the sensitivity of a bond’s price to changes in interest rates, which is important to a bond

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8 • 12 PORTFOLIO MANAGEMENT TECHNIQUES

portfolio manager. Finally, depending upon what protection is needed, duration provides the key to immunizing a
portfolio.
In summary, duration does the following for a bond or bond portfolio:
• Captures its effective average maturity
• Measures its interest rate sensitivity
• Aids in immunizing it against interest rate sensitivity

PROPERTIES OF DURATION
For a stock portfolio, the statistic for measuring sensitivity to market movements is the portfolio’s beta, which is
equivalent to the dollar-weighted sum of the individual stock betas. Similarly, for a bond portfolio, the sensitivity to
interest rates is the portfolio’s modified duration, which is equivalent to the dollar-weighted sum of the individual
bonds’ modified durations.
A bond portfolio’s modified duration has five general properties, as follows:
1. A portfolio’s modified duration is the dollar-weighted sum of individual bond modified durations.
2. The proportional change in a bond’s price following a yield change is the product of modified duration and the
change in a bond’s yield to maturity.
3. For the same maturity, the higher a bond’s coupon rate, the lower its modified duration.
4. For the same maturity, the higher a bond’s yield to maturity, the lower its modified duration.
5. For the same coupon, the longer a bond’s term to maturity, the greater its modified duration, except possibly
when it is trading at a discount.

Let us look at the above properties individually.

PROPERTY 1
A bond portfolio’s modified duration is the dollar-weighted sum of individual bond modified durations, and is
calculated using the following formula:
m
Pk (8.4)
Dp = å P ´D
k =1
k

Where:
Dk = The modified duration of the kth bond in the portfolio
m = The number of bonds in the portfolio
Pk = The market value of the kth bond in the portfolio
P = The total market value of the bond portfolio

The modified duration is determined by the following formula:

Macaulay Duration (8.5)
Modified Duration =
(1 + ( y k ))
This adjustment allows the change in a bond’s price due to changes in interest rates to be expressed as the product
of modified duration and the change in the bond’s yield. The formal result that practitioners use is represented by
the second property of modified duration.

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8 • 13

PROPERTY 2
The proportional change in a bond’s price following a yield change is the product of modified duration and the
change (Δ) in the bond’s yield to maturity, and is calculated as follows:
DP (8.6)
= -Modified Duration ´ Dy
P
The corresponding formula for the Macaulay duration is as follows:
DP -Macaulay Duration
= ´ Dy
P (1 + ( y k )) (8.7)

EXAMPLE
A Bond's Sensitivity to Interest Rates Using Duration
Consider the 8% coupon and zero-coupon bonds used in Table 8.3, and assume that for each of the bonds, the
yield increases from 6% to 7%. The 8% bond’s price is originally $1,070.20, and the change in yield from 6% to
7% causes the price to fall by $35.83 to $1,034.37. Equation 8.7 can be used to calculate how much the bond’s
price should change given this 1 percentage point increase in its yield to maturity.
- 3.52
´ 0.01 = -3.42%
(1 + 0.03)
Given the bond’s original price of $1,070.20, the percentage decline predicted by the modified duration translates
into a price decline of –3.42% × $1,070.20 = $36.57.
While the modified duration predicted a decline in price equal to $36.57, the bond’s price actually declined by
only $35.83 or 3.35%. The slight discrepancy in this price change is due to the fact that equations 8.6 and 8.7 are
only accurate for very small changes in yield to maturity. The duration changes slightly as interest rates change,
but the approximation is extremely close and the process is effective in determining the bond’s price change.
The discrepancy can be completely corrected by factoring in the bond’s convexity. (Refer to CSI’s Investment
Management Techniques™ course for a more thorough discussion on convexity.)

A few other properties are apparent from the formula for duration. Since early interest payments decrease the
duration, a higher coupon will decrease the weight placed on the later payments, which brings us to the next
property of duration.

PROPERTY 3
For the same maturity, the higher a bond’s coupon rate, the lower its modified duration.
In a similar way, a bond’s yield to maturity has less of an effect on later payments if it is lower, which leads to the
fourth property of modified duration.

PROPERTY 4
For the same maturity, the higher a bond’s yield to maturity, the lower its modified duration.

PROPERTY 5
On the other hand, although it seems natural that a longer maturity would be associated with a greater modified
duration, for a deep-discount bond with a long maturity, increasing its maturity can actually decrease its modified
duration. The falling price makes early payments relatively more significant in the calculation. Therefore, for the
same coupon, the longer a bond’s term to maturity, the higher its modified duration, except possibly when it is
trading at a discount.

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8 • 14 PORTFOLIO MANAGEMENT TECHNIQUES

PASSIVE PORTFOLIO MANAGEMENT

BUY-AND-HOLD STRATEGY
As the name suggests, a buy-and-hold strategy means purchasing bonds with available funds and holding each
bond to its maturity, thereby avoiding the interest rate risk on an early sale. This approach should be designed so
that a portfolio’s cash flow needs are met by the sale of bonds that are maturing. There will always be an adequate
supply of bonds with a one-year maturity, which can be sold at close to par, if necessary. With normal planning of
impending requirements, maturing bonds can be reinvested in T-bills for short periods. This strategy’s effect is to
ensure that, while the portfolio’s value may rise and fall inversely with interest rates, the value of bonds that are
sold or maturing will always be close to par. The fluctuations in the portfolio’s value are then inconsequential in
terms of delivering the required funds on schedule.
However, it is important to note that holding a bond to maturity does not necessarily guarantee the goal of
receiving a yield to maturity that is equal to the bond’s original coupon rate or its yield to maturity at the time of
purchase. The reinvestment of coupon payments will likely not be at the bond’s coupon rate or yield to maturity
at the time of purchase due to the volatility of market yields over the life of the bond. If interest rates rise over the
period, the realized yield will be higher than the bond’s coupon rate or yield to maturity at the time of purchase, and
vice versa.
There are two portfolio structures that achieve the goal of receiving a yield to maturity that is equal to a bond’s
original coupon rate or yield to maturity at the time of purchase: the barbell and the laddered portfolios. In a
barbell portfolio, bonds are initially purchased at both ends of the term structure — that is, the portfolio consists
of 30-year and one-year bonds. Each year, new one-year bonds are purchased to maintain the short end as the old
ones mature. At the same time, as the maturity of the long bonds decreases to 29 years, they are sold and replaced
by new 30-year bonds. With a rising yield curve, the required 29-year yield is slightly lower than the 30-year yield,
so the bonds can be sold at a slight premium. However, the difference in rates is minimal. The portfolio is once more
a 1–30 barbell. The weighting of the two ends depends on the portfolio manager’s willingness to accept risk for
return, as more long bonds will expose the portfolio to more interest rate risk.
In a laddered portfolio, bonds are initially purchased with each maturity up to 30 years in equal proportions. After
the first year, each n-year bond is now an (n–1)–year bond — that is, the original one-year bonds mature and are
replaced by the original two-year bonds, which now have one year remaining to maturity. At the long end, there
are no 30-year bonds, because they are now 29-year bonds. The portfolio is rebalanced by using the proceeds of
the maturing bonds to reinvest in 30-year bonds. Changes in the yield curve are likely to cause the weights in each
maturity to vary slightly in market value. Adjustments can be made but are not necessary. Over time, each maturity
will return its original face value when redeemed.
Of the two portfolio structures, the barbell portfolio offers more flexibility in weighting and is more accommodating
for cash. The laddered portfolio can only release one-thirtieth of its value each year. A greater fund requirement
would call for the sale of a longer bond, which would then detract from the 30-year bond’s replacement. Generally,
these passive strategies are aimed at portfolios with no cash demands or net positive inflows, and where cash flow
is not a consideration. The issue of meeting specific cash flow needs will be explained later in this chapter.

BOND INDEX FUNDS

The general idea behind a bond index fund is similar to that of stocks. The intent is to create a portfolio that mirrors
a bond index’s performance and that requires no active security selection. The indexes most often replicated in
Canada are the FTSE TMX Global Debt Capital Markets (formerly PC-Bond/DEX). While a fund can easily duplicate
a stock index’s holdings, it is far more difficult to duplicate a bond index. There are generally many more index
members in a bond index than there are in a stock index. Furthermore, many bonds are so thinly traded that their
weights cannot be adjusted very easily. This adjustment issue is complicated by a bond’s limited investment life,
a problem that does not arise for equities. Bonds with maturities that fall below one year are dropped from most
indexes, while new issues must be added. These adjustments must be matched by any index fund. At the same

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8 • 15

time, the coupon income from a bond index is much higher than the dividend income from a stock index. All of the
coupon interest must be reinvested.
With all of these complexities, it is virtually impossible to exactly duplicate an index’s composition. Instead, as an
effective substitute, two methods can be employed to replicate a bond index. The first is cellular, or stratified,
sampling. The characteristics that affect a bond’s value are its maturity, coupon and credit risk. A bond universe can
be described by these three attributes.

EXAMPLE
If a bond index is classified by 29 different year-to-maturity categories (2 to 30), 24 different coupon levels
(0.5% to 12%) and eight different credit rating agency categories (D to AAA), this gives it 5,568 cells
(29 × 24 × 8).

The percentage of the bond universe that exists within each cell is applied to the fund’s total capital, and
representatives of each cell are bought in proportion.

EXAMPLE
For a $500 million portfolio, if the 10-year 6.5% A+ cell is 0.05% of the bond universe, the fund would place
$0.25 million in some 6% to 6.5% A+ bonds with maturities of between nine and 10 years.

A bond index fund is achieved by creating a cellular portfolio, which is a portfolio designed with cells in each of the
three attributes — maturity, coupon and credit risk — containing representative bonds in proportions that match
the market proportions of the bonds in each cell.
Indexed portfolios created by the cellular approach have proven to be very successful in tracking a bond index. To
be effective, the stratification must be fairly detailed and, consequently, a large portfolio must be created in order
to fill each cell appropriately. This method works well in a bond market as large as in the U.S. But, unfortunately, in
Canada, with its smaller and more illiquid market, this approach is difficult to follow.
The second method of index replication is known as tracking error minimization. This approach uses historical
data to model the tracking error variance for each bond in an index, then minimizes the model’s total tracking
error. A bond’s tracking error is statistically estimated as a function of its cash flows, duration and other sector
characteristics. Quadratic programming is applied to find the optimum index portfolio of minimized tracking error.

DIVE DEEPER

Cellular Sampling Versus Tracking Error Minimization

On one level, the methods of cellular sampling and tracking error minimization are complementary. The
cell matching of sampling tries to replicate an index’s attributes, while the optimization of the tracking
error minimization model only tries to replicate an index’s return stream.
On another level, there are some definite drawbacks to each method. One problem with cellular
sampling is that matching some cells is more critical than matching others, because the volatility
associated with them is higher. Failure to get a close match results in a higher tracking error in the index
fund. The cellular sampling method also ignores correlations between cells, which results in the risk from
an overweight in one cell to be cancelled with an overweight in another.
The tracking error minimization model relies on historical volatilities and correlations between different
risk factors in the market. Thus, the variance model is limited to the historical experience over the
observation period and may therefore neglect a significant change that has not yet resulted in return
volatility. Furthermore, the quality of the quadratic programming is heavily dependent on the quality of
the historical data. As it is difficult to secure enough data regarding each bond in the index, the tracking
error minimization method is very difficult to implement.

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8 • 16 PORTFOLIO MANAGEMENT TECHNIQUES

IMMUNIZATION
Immunization can be viewed as a means of protecting a bond portfolio from interest rate risk. For example,
a financial institution may use immunization to shield its statement of financial position against the maturity
mismatch of its assets and liabilities. Regulatory concerns and shareholder responses motivate financial institutions
to minimize these mismatch problems. For example, pension funds use immunization to ensure that an investment
will mature with the exact amount needed on a certain date. This can be achieved by finding a zero-coupon
instrument that matures on the target date. However, there are other more sophisticated approaches, such as the
duration matching procedure that is described below.

MATCHING DURATION
In the previous discussion of a financial institution’s goals, the mismatch between the maturity lengths of the
assets and liabilities was noted. To be precise, it is the difference in the duration of the assets and liabilities that is
of concern. When interest rates rise, banks find that fixed-term, fixed-rate loans, which are financed by floating,
lower-rate deposits, become less profitable. The profit spread narrows until new loans can be issued at higher
market rates. The durations of the loans and deposits must be matched to eliminate the so-called gap that causes
the spreads to narrow and widen. If the portfolios of assets and liabilities have equal durations, then, according
to Property 2 of duration (as described previously), both portfolios will change in value equally and the financial
institution’s net position is immunized. This approach is more flexible and more practical than achieving an absolute
match in maturity between groups of loans and deposits with the same total value.
For the pension industry, the obligation to make a future payout creates a need for a portfolio of fixed income
instruments with a duration that matches the timing of the payout. While a discount bond maturing at that time
will be satisfactory, it may not be available. Instead, a coupon bond with the correct duration will suffice; this means
a bond with a maturity longer than the duration. The consequences are such that the bond must be sold on the
payout date at a price that, together with the interim interest payments and subsequent earnings on them, equals
the required payout. The bond’s price will fall if interest rates rise (price risk), but the accumulated earnings on the
interest payments will rise (reinvestment rate risk), with the opposite offsetting moves to an interest rate decrease.
It is important to note that this analysis examines the portfolio’s accumulated value as of the payout date, rather
than its present value.
This process is described as target date immunization. The strategy’s success depends in part on the path of
interest rates over the investment horizon. For example, suppose interest rates did not change and interest
payments were reinvested as received at a fixed rate for the period remaining until the payout date. If interest rates
were to increase up to the final date following the last interest payment before payout, the accumulated value
of the interest payments would be unaffected, but the bond’s selling would fall, causing a drop in the portfolio’s
available value.
To be successful, the interim interest payments must be reinvested at the floating rate and at the same rate acting
on the bond. This implies a flat yield curve, which occurs infrequently. In fact, the portfolio needs to be rebalanced
to ensure that its duration remains the same as the payout time over the length of the process. If interest rates
change, rebalancing will be needed, as the portfolio’s duration is inversely related to its yield (Property 4). Even
if interest rates remain the same, the portfolio’s maturity falls over time and, as per Property 5, its duration will
also fall, but at a slower pace. Meanwhile, the duration of the liability is equal to the time remaining, so it is out of
balance with the asset duration.
Contingent immunization is often used as a compromise between passive and active management. In this case,
the manager is willing to risk some of the portfolio’s value in the practice of active management, but at a certain
lower level, they would want to protect themselves against further losses. Assume the manager wishes to guarantee
a certain minimum value for the portfolio by a specified target date. At present, the portfolio’s value is such that
a zero-coupon bond could be purchased to return a value in excess of the desired amount on the target date.
The manager follows an active management strategy until a trigger point occurs, meaning the point where the
portfolio’s value reaches the level at which a zero-coupon bond will mature to the target amount.

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8 • 17

EXAMPLE
Contingent Immunization
Suppose that $100 million is desired in five years and the current market yield is 7%. This means a minimum of
$71.3 million ($100 million ÷ 1.075) invested at the current yield is needed today to attain the desired amount.
The portfolio is currently worth $80 million. The trigger point, which in this case is $71.3 million, is the minimum
value with t years left when a yield of y prevails, such that it equals $100 million ÷ (1 + y)t — we will refer to
this amount as V(y,t). The manager can invest actively, but must monitor the amount [V(y,t)] and compare it
with the portfolio’s value to see if it is triggered. If triggered, the portfolio is immediately rebalanced to create
an immunized position. Note that in Figure 8.2, the trigger point is a rising function of time, although the
smooth diagram represents a constant market yield. The contingent immunization is triggered at point t*. If the
portfolio’s value never falls to the curve V(y,t), it will continue erratically to a higher level at the horizon, rather
than rising smoothly along the curve.

Figure 8.2 | Contingent Immunization

Portfolio Value

100
$ (Millions)

80
71.3

Trigger point

t* 5 years
Time

Portfolio Value

100
$ (Millions)

80
71.3

Trigger point

5 years
Time

CASH FLOW MATCHING

It was suggested earlier that purchasing zero-coupon bonds — or other pure discount bonds, such as T-bills — that
are due to reach maturity at the time of any cash payout will totally immunize a portfolio against interest rate
changes. Provided the instruments are available, this process, known as a dedication strategy, can be adopted for an
indefinite horizon, though at the risk of some liquidity. Unfortunately, this strategy breaks down when one considers
that pension funds generally have an infinite horizon of payouts. However, it is possible to estimate the duration of

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8 • 18 PORTFOLIO MANAGEMENT TECHNIQUES

an asset or liability with an infinite life. As such, it appears the standard immunization approach will be part of any
process, even if some dedication is used to match cash flow.

ACTIVE PORTFOLIO MANAGEMENT

Active portfolio management refers to strategies intended to benefit from changes to current interest rates or from
some mispricing in the market for competitive instruments. Active management begins with a prediction about
the direction of interest rates or the relative yields of alternative instruments. Various market participants may see
opportunities to improve their positions by exchanging holdings from one instrument to another. The portfolio
remains invested in fixed income to the same degree — there is no adjustment to asset allocation. Essentially, the
end result of the analysis is to rebalance the portfolio to a preferred allocation within the fixed income sector.

INTEREST RATE ANTICIPATION

Much of the attention of Wall Street and Bay Street is focused on the actions and predicted actions of the U.S.
Federal Reserve Board or the Bank of Canada. The question is always whether they will raise or lower interest rates,
which is complicated when considering if a change in short-term interest rates will translate to a similar shift in the
remainder of the yield curve. Conceivably, increasing short-term interest rates may reduce inflationary expectations
so that the long rate will not rise. Aside from central bank economists, private sector economists issue forecasts
for inflation, economic growth and long rates. Based on assorted and often conflicting information, a fixed income
portfolio manager must decide whether to position their portfolio with a longer or shorter duration.
This positioning mechanism is referred to as a rate anticipation swap, where funds are moved from one end of
the yield curve to the other. If interest rates are expected to fall, locking in higher rates for a longer period will be
profitable. Extending the portfolio’s maturities and the duration of the portfolio will result in an increase in its value.
Conversely, if interest rates rise, long-term (or long-duration) bond prices will fall more than short-term (or short-
duration) ones and the portfolio will benefit from a shift to a shorter duration. In the extreme, a rise in interest rates
would indicate to those with perfect foresight that they should move all of the portfolio’s funds into 30-day T-bills,
while a fall would indicate a move to 30-year bonds. Prescient portfolio managers would always invest entirely
in either long- or short-duration bonds, unless no change is anticipated. Even in that case, a normal rising yield
curve would indicate long-duration bonds, except for any short-term cash requirements. However, since no one
has perfect foresight, a portfolio manager’s response is to make shifts in average duration at a magnitude that is in
proportion to the manager’s convictions.
In determining how to react to a forecast, an analyst uses a technique known as horizon analysis. The analyst
chooses a horizon over which the interest rate change is expected to evolve and at the end of which a new yield
curve is predicted. Swapping two bonds for that period entails a difference in price for the two bonds at the end of
the horizon. During the period, there is also a difference in coupon interest, which is to be reinvested at predicted
rates that are consistent with the yield curve evolution.
If no change in the level of interest rates is expected, investors can ride the yield curve. Since a normal yield curve
is concave and upward sloping, yields get progressively smaller as bond maturities get shorter. A five-year bond
could be priced to yield 4.5%, with four-year bonds yielding 4%. Purchasing a five-year bond priced at par leads to a
capital gain if it is sold one year later and the yield curve has not shifted.
For example, using Equation 8.2, a five-year bond with a coupon of 4.5% is worth $1,000 if its yield is 4.5%. One
year later, assuming an unchanged yield curve, it is now a four-year bond yielding 4%, so its price is $1,018.32.
Riding the yield curve results in a capital gain of almost 2%. This amount is then reinvested in another five-year
bond offering 4.5%, which is again sold after another year elapses. The success of this strategy depends on the
absence of change in the yield curve.

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8 • 19

EXAMPLE
Riding The Yield Curve
A portfolio manager of a $10 million fixed income portfolio, consisting of one Government of Canada (GoC)
bond (Bond C) with 10 years to maturity, has recently updated her interest rate forecast and expects little
change in the shape of the GoC yield curve over the next year. She decides that the best interest rate anticipation
strategy involves repositioning the portfolio to ride the yield curve more optionally.
Upon closer inspection of the GoC yield curve, the manager observes a slight kink in the yield curve around the
10-year mark. She attributes this to the extra demand associated with the highly liquid benchmark 10-year bond
issue. She inputs her no-change scenario for the yield curve into her horizon analysis to evaluate opportunities in
the middle portion of the yield curve. The manager produces the following table of figures pertaining to four GoC
bonds.

Bond A Bond B Bond C Bond D

Currently
Time to Maturity 8 years 9 years 10 years 11 years
Yield to Maturity (YTM) 7.0% 7.1% 7.2% 7.5%

One-Year Horizon
Time to Maturity 8 years 9 years 10 years
Expected YTM 7.0% 7.1% 7.2%
Change from Last Year’s YTM –0.1% –0.1% –0.3%
Expected Total One-Year Return 7.7% 7.9% 9.6%

The expected total one-year return includes the coupon payment and the capital gain, assuming all bonds are
currently trading at par, resulting from the declining yields.
In light of her analysis, the manager sells the $10 million position in Bond C and purchases $5 million in market
value for each Bond B and Bond D. The manager estimates that this trade leaves the portfolio’s modified duration
unchanged and increases its convexity marginally. She concludes that the portfolio’s interest rate risk has
changed very little. However, based on her yield curve forecast, the portfolio’s total expected return from riding
the yield curve has increased from 7.9% to 8.65% [(7.7% + 9.6%) ÷ 2]. Of course, if the manager’s no-change
forecast for the yield curve proves to be inaccurate, the portfolio’s realized return over the next year may be
higher or lower than this estimate.

BOX TRADES
Before describing the mechanics and rationale of a box trade, , it is important to first review the rationale for and
execution of a standard bond swap or trade.

BOND SWAPS
Bond swaps normally involve the purchase of one bond and the simultaneous sale of another related or unrelated
bond. The motivation for a fixed income swap is for the portfolio manager to potentially profit from the correct
analysis of the proper value of the yield spread between the two fixed income securities. The portfolio manager then
structures and executes the trade or swap to capture this assumed market opportunity.

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For example, Table 8.4 shows the standard statistical parameters normally considered when a fixed-income
portfolio manager determines whether a particular pair of bonds should be swapped. The table shows the summary
statistics for the daily closing yield spread between two particular bonds over a period of two years.

Table 8.4 | Historic Yield Spread

Government of Canada (Five-Year Maturity) Versus Company X (Five-Year Maturity)

Yield Spread During the Prior Two-Year Period (Basis Points)
+2/-2 Standard Deviations 85/15
+1/-1 Standard Deviation 60/40
Mean 50

In this example, if the current yield spread between the two five-year maturity bonds is, say, 53 basis points, there
would not be a strong argument based on their historic yield spread relationship to support the initiation of a
fixed income swap, since their current yield spread is very close to the historic mean value. This infers that the two
securities are properly valued when compared to one another and thus accordingly, there is no incentive to enter
into a swap.
Alternatively, if the current yield spread between the two bonds is, say, 66 basis points, the Company X bond is
trading more than one standard deviation wider, or cheaper, versus the GoC bond of the same maturity. Stated in
probability terms, the current yield spread is greater than what it was over almost 70% of the time during the past
two years.2 The portfolio manager might decide that the current yield spread is supportive of selling the GoC bond
and to use the proceeds to purchase the Company X bond. Of course, the portfolio manager is anticipating that the
yield spread will decrease or narrow, and a gain on the swap can then be realized.
The fixed income swap will be reversed at a future point in time when either of the following occurs:
• The yield spread for the swap has moved in a favourable direction and has reached the portfolio manager’s
target spread, wherein he decides to reverse the trade and realize the profit; or
• The yield spread has not moved in a favourable direction and the portfolio manager decides to reverse the trade
and take the loss.

EXAMPLE
Reversing a Fixed Income Swap
Reversing a fixed income swap or trade involves the following:
• Selling the fixed income security that was purchased at the initiation of the swap; and
• Purchasing the fixed income security that was sold at the initiation of the swap.

The result is that the swap has been reversed and the portfolio has been returned to the same position it was in
prior to the initiation of the fixed income swap.

2
The mean of 50 is a given number in this example. Approximately 68% of all yield spreads for the two five-year maturity bonds lie within 1
standard deviation (above or below) of the mean. The reference to 70% of the time is rounded from “approximately 68% of all yield spreads
for the two five-year maturity bonds lie within 1 standard deviation”. The yield spread of 66 basis points is outside of the 60-basis point yield
spread to 40-basis point yield spread, which has occurred approximately 68% of the time over the last two years.

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EXAMPLE
Bond Swap
Since the two bonds were issued almost three years ago, a portfolio manager has made several profitable bond
swaps between a Northern Bank Ltd. senior bond (5.75% due 6/30/28) and a U.S. Treasury bond (4.85% due
6/15/28). Assuming a normal distribution, the daily yield spread between the two bonds displays the following
parameters over the past three years.

Yield Spread – Northern Bank Ltd. Bond (5.75% due 6/30/28) Versus U.S. Treasury Bond (4.85% due
6/15/28)
Yield Spread (Basis Points)
+2 Standard Deviations +90
+1 Standard Deviations +80
Mean +65
-1 Standard Deviations +50
-2 Standard Deviations +40

The portfolio manager has found the following swaps to be profitable:

• Swap initiation: Sell the U.S Treasury bond and buy the Northern Bank Ltd. bond when the yield spread is
greater than 80 basis points.
• Swap reversal: Sell the Northern Bank Ltd. bond and buy the U.S Treasury bond when the yield spread is
greater than –50 basis points. (Note this yield spread is negative, since when reversing the swap, the portfolio
manager is selling the higher-yielding bond and buying the lower-yielding bond.)

Currently, the two bonds have the following market yields, prices and yield spreads, respectively.

Yield to Maturity (YTM) and Market Value at Swap Initiation

Bond YTM (%) Market Value (per $100 Bond)
Northern Bank Ltd. Bond (5.75% due 5.29 103.50
6/30/28)
U.S. Treasury Bond (4.85% due 6/15/28) 4.47 103.04
Difference +0.82

The yield spread is greater than 80 basis points, which is the threshold level to initiate the swap, so $1 million of
the U.S. Treasury bond is sold and the proceeds are invested in $1 million of the Northern Bank Ltd. bond.

Forty days later, the bond market has sold off and, accordingly, all yields are higher. Both bonds have suffered
capital losses due to the increase in interest rates; however, the yield give-up between the two bonds is now 51
basis points, which is at the threshold level to reverse the swap. The two bonds now have the following YTMs and
market prices.

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EXAMPLE
Bond Swap – cont'd
YTM and Market Value at Swap Reversal
Bond YTM (%) Market Value (per $100 Bond)
Northern Bank Ltd. Bond (5.75% due 5.80 99.62
6/30/28)
U.S. Treasury Bond (4.85% due 6/15/28) 5.29 96.62
Difference -0.51

The net profit after reversing the swap is as follows:

• Swap initiation (selling the U.S. Treasury bond minus buying the Northern Bank Ltd. bond): $103.04 –
$103.50 = –$0.46 (or a net cost of $0.46 per $100 bond).
• Swap reversal (selling the Northern Bank Ltd. bond minus buying the U.S. Treasury bond): $99.62 – $96.62 =
$3.00 (or a net receipt of $3.00 per $100 bond).
• The net profit on the swap: –$0.46 + $3.00 = $2.54 (or a net profit of $2.54 per $100 bond).

Despite the sell-off in the bond market, the bond portfolio has a higher market value of $2.54 per $100 bond,
and the portfolio is invested in the exact same manner it was 40 days earlier. This is the direct result of the
31-basis point narrowing of the yield spread between the two bonds.

DUAL BOND SWAP (BOX TRADE)

With the knowledge of a standard fixed income security trade or swap, it is easier to understand the structure of
a box trade since it involves the simultaneous execution of a pair of related fixed income security swaps. They are
related in that the pair of swaps involves the securities of the same two bond issuers. It is referred to as a box trade
because the pair of bond swaps is commonly depicted as a box on a yield curve diagram. The yield curve in Figure
8.3 depicts a box trade involving the bonds of two issuers — A and B — and immediately below it is a table listing
the four bond transactions that constitute the two bond swaps.

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Figure 8.3 | Box Trade – Bonds from Issuers A and B

Transaction 3
Issuer B
Sell Issuer B’s
Y-term bond
Transaction 2
Buy Issuer B’s
X-term bond
YTM (%)

Issuer A

Transaction 4
Buy Issuer A’s
Transaction 1 Y-term bond
Sell Issuer A’s
X-term bond

Term to Maturity (Years)

Swap Transaction
1 Sell Issuer A’s X-term bond
1
2 Buy Issuer B’s X-term bond
3 Sell Issuer B’s Y-term bond
2
4 Buy Issuer A’s Y-term bond

The objective of a box trade is to profit from the potential market revaluation of the respective yield spreads for
either or preferably both of the two fixed income swaps. In essence, the portfolio manager uses a box trade when
they believe the yield curve for the higher-yielding issuer will either steepen or flatten relative to that of the lower-
yielding issuer.
The portfolio manager employs this type of trade when they believe the yield spreads for each of the two pairs of
fixed income swaps have reached a sufficiently attractive magnitude, which is either too small or too large, so that
both of the swaps should be initiated. Normally, the portfolio manager makes this valuation assessment based
on the statistics of the historic yield spread relationship between the two bonds being traded in each of the two
respective contemplated swaps.
In the example above, the portfolio manager believes Issuer B’s yield curve will steepen relative to that of Issuer
A’s yield curve. Conversely, if the portfolio manager believed Issuer B’s yield curve would flatten relative to that of
Issuer A’s yield curve, the opposite of the four transactions would occur — that is, sells would become buys, and
buys would become sells.
However, in addition, the combination of the pair of swaps that constitute a box trade must also satisfy the
following parameters for or constraints of the total fixed income portfolio:
• No change in the portfolio’s overall duration
• No change in the portfolio’s overall credit risk exposure
• No change in the amount of the portfolio’s assets invested in each of the two credits involved in the box trade

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With these additional constraints, a properly structured box trade does not result in any changes to the total
portfolio’s interest rate exposure, overall credit risk exposure and amount of exposure to specific issuers. The
structure of the box trade only provides exposure to the change in the relative yields between the two issuers.
Two of the most popular types of box trades that Canadian institutional fixed income portfolio managers execute
are discussed below.

INTERMARKET DOMESTIC BOX TRADE

An intermarket domestic box trade involves four transactions of four domestically issued fixed income securities
from two Canadian bond issuers. Figure 8.4 shows an example involving the five-year and 10-year maturity bond
issues from ABC Inc. (a Canadian company) and the GoC, respectively. The table at the bottom of Figure 8.4 shows
the four market transactions that would be executed if the portfolio manager believed that ABC Inc.’s yield curve
was going to flatten versus the GoC’s yield curve.

Figure 8.4 | Box Trade – GoC and ABC Inc. Bonds

Transaction 3
ABC Inc.
Buy ABC
10-year bond
Transaction 2
Sell ABC
5-year bond
YTM (%)

GoC

Transaction 4
Sell GoC
Transaction 1 10-year bond
Buy GoC
5-year bond

5-year 10-year
Term to Maturity (Years)

Swap Transaction
1 Buy Government of Canada 5-year bond
1
2 Sell ABC 5-year bond
3 Buy ABC 10-year bond
2
4 Sell Government of Canada 10-year bond

If the portfolio manager’s outlook is correct, a gain would be realized on the narrowing of the yield spread between
the two bonds involved in the 10-year swap. Of course, the flattening of the yield curve would also potentially affect
the spread between the two bonds involved in the five-year swap. If the spread between the two five-year bonds
decreases, there would be a loss that would reduce the gain on the 10-year swap. Of course, if the yield spread
increases between the two bonds involved in the five-year swap, a gain would also be realized and added to the gain
on the 10-year swap.

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INTRAMARKET BOX TRADE

An intramarket box trade is another popular type of box trade that Canadian institutional fixed income portfolio
managers perform that involves bonds issued by the Canadian and U.S. governments. In this case, the portfolio
manager is speculating on the change in slope or spread between two points on the yield curves of these two
governments, respectively. If the portfolio manager believes the yield curve for GoC bonds is going to flatten versus
the yield curve for U.S. government bonds, the type of trade would appear as in Figure 8.5, and would involve the
four transactions in the table below it.

Figure 8.5 | Box Trade – GoC and U.S. Government Bonds

Transaction 3
GoC
Buy GoC
10-year bond
Transaction 2
Sell GoC
5-year bond
YTM (%)

U.S.

Transaction 4
Sell U.S.
Transaction 1 10-year bond
Buy U.S.
5-year bond

5-year 10-year
Term to Maturity (Years)

Swap Transaction
1 Buy U.S. Government 5-year bond
1
2 Sell Government of Canada 5-year bond
3 Buy Government of Canada 10-year bond
2
4 Sell U.S. Government 10-year bond

The gains and losses from this intramarket box trade would occur in a similar manner as the previously mentioned
box trades.

OTHER BOND PORTFOLIO CONSTRUCTION TECHNIQUES

In addition to the basic passive and active management approaches discussed previously, there are more modern
instruments and techniques used today. These reflect the response of the securities industry to changing financial
conditions. Much of the innovation originates from the drastic increases in interest rates in the 1970s, when
investors looked for better alternatives to bank deposits and government securities.

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Today, portfolio choices include many alternatives to conventional bonds. A corporation’s financial assets, such as
mortgages and receivables, can be bundled and sold as short-term instruments with good security. The process
of turning relatively illiquid assets into tradable securities is known as securitization. Also, there are some well-
developed risk management strategies in conventional bond portfolios using derivatives. Some of the most popular
instruments and derivative strategies are presented below.

ASSET-BACKED SECURITIES
Corporations regularly find themselves with current assets, which are classified as receivables, that represent the
debt of customers who purchase goods or services from them. These receivables are likely to be home equity loans;
auto loans; credit card receivables; student loans; home improvement loans; trade receivables; or equipment leasing
on operating assets, such as planes and ships. Corporations and auto dealers regularly finance their inventories by
borrowing from banks and other financial institutions, pledging their inventories as security for repayment. It is also
common for corporations to pledge their accounts receivables to factors that advance cash against the repayment
of the receivables on various terms. Factoring is a profitable, if risky, business.
More recently, the role of the factor has been appropriated by corporations that have their receivables assembled
into packages of loans that are then securitized and sold to investors as asset-backed securities (ABS), which are
a type of bond with cash flows that are supported by the cash flows from a specified pool of underlying assets. The
pooling adds liquidity to otherwise illiquid assets, while also reducing risk by diversifying the underlying portfolio.
An ABS offers competition to T-bills and commercial paper. It provides another vehicle for the placement of short-
term funds with a slightly higher yield, while retaining security and liquidity. It becomes a suitable alternative for
portfolio managers to choose from when designing their fixed income funds.

CREATING AN ABS
The originator of loans can securitize its pool of receivables, rather than issue corporate bonds to finance them.
The first step in creating an ABS is to sell the assets to a legal entity called a special purpose vehicle (SPV). The
originator sets up the SPV, typically as a trust. It is the legal owner of the loans and is separate from the originator.
The SPV buys the loans and sells the securities, which are backed by the loans, to investors in exchange for cash, and
uses this cash to pay the originator. An SPV that is created by a party not related to the originator is called a conduit,
which essentially fills the same role as the SPV set up by the originator.
The trust’s credit risk is improved using credit enhancement facilities, which are discussed below. The trustee collects
the cash flow generated by the assets, and is responsible for distributing the interest and principal payments to the
investors and the servicing fees to the loan servicer. The loan servicer’s role is to send monthly payment statements,
collect monthly payments, maintain records of payments and balances, collect and pay taxes and insurance, and
follow-up on delinquencies. The basic structure of an ABS is illustrated in Figure 8.6.

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Figure 8.6 | Basic Structure of an ABS

Obligors

Servicing Fees Seller/Servicer Liquidity

Cash Flow Credit

Trustee Trust (SPV) Enhancement

Issues ABS
Principal and
Interest Payments
Investors

CREDIT ENHANCEMENT FACILITIES

An ABS needs various forms of internal and external credit enhancements to upgrade the risk-return profile of the
underlying receivables. Credit enhancements reduce the credit risk for investors, thereby increasing the rating on
the investor certificates and lowering the ABS issuer’s funding costs. One or more credit enhancement facilities are
usually required in order to receive a high enough debt rating to make the certificates readily marketable.

EXTERNAL CREDIT ENHANCEMENTS

The credit risk of an ABS can be reduced by using third-party guarantees to provide for first-loss protection (losses
on collateral due to the first defaults) up to a specified level. The most common forms of third-party guarantees
are bond insurance and pool insurance. Bond insurance is a financial guarantee from an insurance company that
guarantees the timely payment of interest and principal if these cannot be satisfied from the pool. Pool insurance
covers losses from defaults and foreclosures. To sufficiently increase the credit rating of an ABS, the third-party
guarantor’s rating must be at least as high as the rating sought. The disadvantage is that if the guarantor’s rating is
downgraded, the securities the insurance guarantees may also be downgraded.
A letter of credit, which is an unfunded commitment by a third party that protects against losses on underlying
assets, is another form of external credit enhancement. Protection is limited to a fixed percentage of collateral. A
bank usually provides a letter of credit in exchange for a fee.

INTERNAL CREDIT ENHANCEMENTS

The credit risk of an ABS can also be reduced internally. A senior/subordinated structure establishes two or more
layers — also known as tranches — of ownership within an ABS. Senior/subordinated classes are structured so that
each position benefits from the credit protection of all of the positions below it. The senior positions get priority
in the payment of both principal and interest over the junior positions. The junior class absorbs any of the initial
losses on the underlying collateral up to a certain percentage of the total principal. When that is exceeded, the
next level up of seniority will absorb the losses up to a certain percentage, and so on. Senior classes are usually sold
to institutional investors, and the selling bank typically retains the most subordinated piece. As compensation for
absorbing the risk, the yields on the lower classes are much higher than those on the senior ones.

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The schedule followed by an ABS that prioritizes the manner in which the interest and principal are paid is known as
the cash flow waterfall. At the top of the waterfall are the senior noteholders and some standard fees and expenses.
At the bottom of the waterfall are the junior classes. The cash flows that remain after all payments are made are
known as the excess spread, which seeds the reserve fund.
Reserve funds are money market deposits held for protection against future losses. Reserve funds are seeded from
either the initial underwriting profits or the excess spread, which is the payment from receivables, net of monthly
coupons, service fees and all other expenses. The excess spread is the first line of defence against collateral losses.
Another internal credit enhancement strategy is overcollateralization, where the principal amount of an issued ABS
is less than the principal amount of the underlying pool of assets backing it.

EXAMPLE
An ABS could be issued for $300 million, but the principal amount of assets backing it is $310 million. The
remaining $10 million of principal provides a cushion in case of default within the original $300 million pool.

MORTGAGE-BACKED SECURITIES
Mortgage pass-through securities were first created in the U.S. in 1970 by the Government National Mortgage
Association, or Ginnie Mae, as it is more commonly known. They were imitated in Canada by the issuance of
mortgage-backed securities (MBS) insured by the Canada Mortgage and Housing Corporation (CMHC) under
the National Housing Act. An MBS is a portfolio of mortgages assembled and sold in tranches to increase mortgage
capital for lenders. It offers secure higher-yielding medium-term investments that are comparable to government
bonds.
To understand an MBS, it is first important to recognize that banks and trust companies no longer wish to lend
funds for individual homes under conventional mortgages. Financial institutions have realized that there is more
profit to be made in issuing and servicing a mortgage — that is, appraising credit, charging fees, advancing the funds,
and collecting and processing monthly payments — than in tying up deposit capital in the loans. It is preferable to
lend $100,000 after the appraisal and collection of initial fees, then sell the mortgage to investors using the CMHC’s
guarantee to get the $100,000 back. At this point, they can lend it again and collect more fees, and then sell it
again, thus leading to a never ending process. The same $100,000 can earn a lot more in initial fees and processing
fees for the monthly payments on each loan.
Most significantly, an MBS adds a lot of liquidity to the market. Investors are happy to buy an MBS, because they
can effectively place money in real estate without facing the risk of default, with the benefit of CMHC’s guarantee,
or the problems related to collections and credit appraisal. The packaging of insured mortgages has the added
benefit of creating a tradable security, the MBS, that comes from nationwide mortgages. The assets are safe and
liquid for investors, and the funds become available for lending to any area without the restriction of local credit
shortages.

PACKAGING AN MBS
The specifics of an MBS program require that financial institutions assemble a portfolio of mortgages that totals
$10 million, for instance, with a common interest rate, term and amortization period. Collectively, this is an MBS,
which is then guaranteed by the CMHC. The MBS is subdivided into individual units; for example, 1,000 units that
are worth $10,000 each with equal claims of 1/1000th of the payment stream from the mortgages contained in
the MBS. The cash flow, as a mortgage payment, is partly interest and partly return of capital. Because mortgages
may have prepayment provisions, which have significant effects on cash flows and yields, an MBS is separately
composed of prepayable and non-prepayable mortgages. Assuming mortgages are more likely to be prepaid when
interest rates are falling, the realized yield on a prepayable MBS will be lower than expected from the interest rates
on component mortgages.

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Investors are attracted to the yield on an MBS. Since an MBS is a fixed-payment instrument with the CMHC’s
guarantee, it is comparable to government bonds. The Government of Canada stands behind the CMHC’s guarantee,
making an MBS relatively equal in security to GoC T-bills and bonds. As such, one would expect the yield on an MBS
to be virtually the same as on government bonds. In fact, there is a clear yield premium on an MBS.

ELEMENTS OF PREPAYMENT RISK

When a fixed income portfolio manager evaluates an MBS for inclusion in their portfolio, they need to judge the
prepayment risk. As mentioned earlier, misjudging the prepayment risk can result in a lower yield on the MBS than
the rate on the underlying mortgages. Examined below are the three factors that determine prepayment risk, as
follows:
1. Housing turnover
2. Cash-out refinancing
3. Rate/term financing

Housing turnover Refers to existing home sales. Turnover is positively correlated with prepayment risk.
Home sales are affected by the following:
• Family relocation due to changes in employment or family status (divorce, marriage)
• Trade-up or trade-down activity attributable to changes in rates, income and home
prices

In other words, people are more likely to change housing when it is more affordable.

Cash-out refinancing Refers to the replacement mortgage of a borrower’s first mortgage in order to monetize
the property’s price appreciation. The replacement mortgage is completed for more than
the principal remaining and the borrower pockets the difference.

EXAMPLE
A person whose principal residence is worth $400,000 with a mortgage of $150,000 can refinance it at
$200,000, pocketing the remaining $50,000.

Adding to the incentive for a borrower to monetize their property’s price appreciation is
the tax law regarding gains on a principal residence. The principal residence exemption
allows homeowners to keep the gains tax-free from the sale or cash-out refinancing of
their principal residence.

Rate/term financing Occurs when a borrower obtains a new mortgage on the same property at a lower
interest cost or shorter term to maturity, with no increase in their monthly payment.
The homeowner’s incentive to refinance is based on the projected present value of
the interest savings, net of the cost to refinance. Rate/term financing activity tends to
increase as the prevailing market mortgage rate becomes lower than the borrower’s
current mortgage rate.

COLLATERALIZED MORTGAGE OBLIGATIONS

A further development from an MBS is a collateralized mortgage obligation (CMO), which exists primarily in the
U.S. In a CMO, the MBS pool is further divided into tranches that make payments based on different segments of
the mortgage cash flows. For example, a fast-pay tranche might receive all of the principal payments from the MBS
until the investment has been recouped, while the other tranches receive only interest payments. Once the fast-pay

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tranche is satisfied, the second tranche begins to receive principal payments until it is repaid, and so on, until all
tranches have been repaid. Interest payments are based on each tranche’s outstanding principal. The ordering of the
tranches results in an earlier to later recovery of capital for each class of investor.
An MBS is a portfolio alternative to a coupon bond, with a readily determined duration. Managers may choose to
invest in an MBS to pick up the extra yield while maintaining a target portfolio duration. The market for an MBS is
relatively liquid, making it an attractive alternative for any of the medium-maturity bonds, as they are linked to
mortgages that are typically renegotiable at five-year intervals. In contrast, for the short end, where maturing bonds
and T-bills are usually found, there are securitized instruments based on short-term assets.

COLLATERALIZED DEBT OBLIGATIONS

A collateralized debt obligation (CDO) is a security that repackages a collection of underlying assets and sells
multiple classes (tranches) of the asset pool’s interest to investors. This allows the restructuring of the pool’s credit
risk into new tranches with different risk profiles than the underlying assets. These are debt obligations that are sold
to investors with different risk appetites.
A CDO is very similar to an ABS in structure and operation, except in the type of securitized asset. An ABS is
supported by a discrete pool of receivables, such as home equity loans, student loans, car loans and credit card
receivables. A CDO’s cash flows are supported by MBS, ABS, leveraged bank loans, real estate investment trusts
(REITs), corporate bonds or even other CDOs.
A CDO has three main components that are similar to an ABS, as follows:
1. An originator, which is typically a bank
2. Investors ready to buy the credit risk
3. An SPV

As discussed earlier in relation to an ABS, an SPV, which is also called a special purpose entity (SPE), is a legal
entity created specifically for each individual CDO. An SPV, which is an independent company from the originating
financial institution, takes over the loans from the bank and issues the CDO tranches against them. Thus, the
SPV’s assets are the loans or other risky debt, and its liabilities are the CDO notes. The separation of the SPV and
the originator actually protects investors from the originator’s default under what is known as the SPV’s default
remoteness.
There are two main types of CDOs: cash and synthetic. A discussion of synthetic CDOs will appear later in this
chapter. Under a cash collateralized debt obligation, the originator sells the collateral (assets) to the SPV for cash.
The collateral is now off the originator’s balance sheet and on the SPV’s balance sheet. The SPV pools all of the
assets and sells them in tranches. There are usually three main tranches — senior, mezzanine and equity — and one
note is issued for each tranche, which is ranked by default likelihood and repayment frequency; that is, seniority of
debt.
The different tranches have different priority claims on the cash flows from the underlying collateral. These tranches
may be rated by agencies, receiving ratings from very senior (senior tranche) to unrated (equity tranche). The equity
tranche is a residual tranche that will receive payment from the collateral pool after the other tranches have been
paid. If a loss or default occurs, it will first be absorbed by the equity tranche, with any additional losses absorbed by
the mezzanine tranche and so on. Figure 8.7 illustrates a cash CDO’s typical cash flows and structure.

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Figure 8.7 | Typical Structure of a Cash CDO

Originator Collateral sold to SPV SPV

Holds collateral Issues CDO notes
(underlying assets according to different
such as loans or bonds) tranches (different
Payment for purchase
seniorities and coupons)
of collateral

Coupon payment

Investors
Invest in CDO tranches,
for example:
1. Senior tranche
(e.g., AAA)
2. Mezzanine tranche
(e.g., A, BBB)
3. Equity tranche
(not rated)

Principal (returned
by SPV at maturity)

EXAMPLE
Typical Cash CDO
An originator pools loans that are worth $200 million. After selling the loans to an SPV, three tranches are
created, as follows:

Attachment Notional Amount Spread

Tranche Points ($ Million) Credit Rating (Basis Points)
Equity 0%–5% 10 Not Rated 1,200
Mezzanine 5%–15% 20 A 125
Senior 15%–100% 170 AAA 10
Total Portfolio 0%–100% 200 A 81

• The equity tranche is responsible for the first 5% of the portfolio’s losses, with attachment points in the
range of 0% to 5%.
• The mezzanine tranche is responsible for the next 10% of the portfolio’s losses, with attachment points in the
range of 5% to 15%.
• The senior tranche is responsible for the remaining 85% of the portfolio’s losses, with attachment points in
the range of 15% to 100%.

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EXAMPLE
Typical Cash CDO – cont'd
What follows are notional amounts that correspond to each of the tranches:
• $10 million for the equity tranche (5% × $200 million)
• $20 million for the mezzanine tranche (10% × $200 million)
• $170 million for the senior tranche (85% × $200 million)

Typically, the equity tranche will not be rated, while the mezzanine tranche will be rated A and the senior tranche
will be rated AAA, for an overall pool rating of A. Commensurately, the equity tranche will generate 1,200 basis
points over U.S. T-bills, the mezzanine tranche will generate 125 basis points and the senior tranche will generate
10 basis points. Overall, the portfolio’s spread over treasuries is 81 basis points, which is the weighted average of
the tranche spreads, calculated as follows:
(0.05 × 1200) + (0.1 × 125) + (0.85 × 10) = 81bps.

Assume there are accumulated credit losses totalling $15 million (7.5%). The equity tranche is the first to absorb
any CDO losses, and does so up to $10 million (5%) of the portfolio. This is why the equity tranche’s yield (1,200
basis points) is so high — the spread has to compensate investors for the added credit risk of every loan in the
pool. Once the equity tranche is used up, the mezzanine tranche absorbs the remaining $5 million (2.5%). The
mezzanine tranche is now at $15 million — 7.5% of the original portfolio — and continues to absorb any future
credit losses. Investors in the mezzanine tranche are now earning the 125-basis point spread on the new $15
million balance.

SYNTHETIC COLLATERALIZED DEBT OBLIGATIONS

A synthetic (CDO) is the credit derivative variant of the cash CDO. In a synthetic CDO, the originator, which is a
financial institution, retains ownership of the underlying assets and buys protection from the SPV using a credit
default swap (CDS), thus swapping the credit risk over to the SPV. This allows the originator to unload the credit risk
while retaining the assets. The SPV inherits the risk structure of the collateral held by the originator and repackages
it into tranches to sell to investors.
It is important to note that the collateral is now a CDS, and the SPV does not buy the underlying assets. Typically, it
uses the proceeds from the CDO tranches to invest in high-quality, low-risk assets, such as treasuries, that generate
the required cash flows for servicing its CDO payment requirements — coupons and the repayment of the principal.
For example, on an interest payment date, the CDO receives the premiums from the CDS, as well as interest on
the high-quality, low-risk assets. The SPV then distributes the interest payments on each tranche according to its
risk level. As with a cash CDO, if a loss or default occurs, the payoff on the CDS is taken from the equity tranche
first (write-down of principal), with additional losses absorbed by the mezzanine tranche, and so on. Figure 8.8
illustrates the cash flows and structure of a standard synthetic CDO.

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Figure 8.8 | Typical Structure of a Synthetic CDO

CDS Coupon
Originator premiums SPV payments High-quality,
Writes CDS Protection/seller in low-risk (e.g., AAA)
with SPV (and the CDS issues CDO assets as collateral
continues to hold notes according to for the SPV
underlying assets) CDS protection different tranches Principal collected
given default (different seniorities from investors
and coupons)

Principal (returned
Coupon payment
by SPV at maturity)

Investors
Invest in CDO tranches,
for example:
1. Senior tranche
(e.g., AAA)
2. Mezzanine tranche
(e.g., A, BBB)
3. Equity tranche
(not rated)

HOW CDOs ARE USED

A financial institution typically initiates a CDO to take certain types of unwanted debt off their statement of
financial position, thus enhancing their on-book debt quality. At the same time, it may repackage some harder-
to-sell debt, making it easier to sell in more investor-specific tranches, thereby increasing the liquidity and market
appeal of the underlying assets. Finally, arbitrage-motivated CDOs may want to benefit from the difference
between the returns on the purchased collateral and the lower weighted-average payments made to the different
tranches.

EXAMPLE
If an SPV makes $50 million a year in returns on the capital received by investors, but needs to pay a total of $30
million yearly to these same investors across all tranches, it will generate a $20 million profit.

Investors benefit from CDOs by accessing risk-specific tranches that suit their needs. For instance, asset and hedge
fund managers may wish to invest in equity tranches for the high return-risk mix they offer, given appropriate
portfolio design and diversification. Prudent investors, such as institutional pension funds and endowments, may
invest in high-grade tranches with high seniority and security. All these investors benefit from the fact that it may
be difficult or impossible for them to directly invest in a large pool of underlying assets, such as those that support
the CDO in which they invest.

CASH VERSUS SYNTHETIC CDOs

Synthetic CDOs have qualities that make them preferable over their cash counterparts for both issuers and
investors. They can be compiled in the marketplace sooner. The time from inception to finish can be as few as four
weeks or, on average, six to eight weeks. On the other hand, cash CDOs usually take three to four months from

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inception to finish. Synthetic CDOs take less time to assemble than cash ones, because it is quicker to find and settle
a CDS, and there is no need to find cash assets in the market first.
With regard to most credit names, a CDS is cheaper than a similar underlying bond. A CDS is a derivative and, like
most derivatives, is cheaper to deal with than an underlying asset. A CDO’s sponsor will pay only a handful of basis
points for a CDS. A cash bond would cost the benchmark yield plus the credit spread, which is a considerably higher
cost.
Banking relationships can be maintained with clients whose loans do not need to be physically sold off of the
sponsor’s balance sheet. To enact the actual sale of a bank loan, the bank’s client has to grant permission. This
would not create a favourable impression with the client, whose confidence in the bank would depart along with all
of the potential fees from the relationship.
Finally, the range of reference assets that can be used in a synthetic CDO is vast and includes illiquid cash
instruments, such as undrawn lines of credit and bank guarantees, that would give rise to true sale issues in a cash
CDO.
Cash CDOs still have some advantages over synthetic ones, such as the originating entity’s lower exposure to
counterparty risk. In a synthetic CDO, the default of a counterparty would stop payments of the premium payments
or, worse, culminate in a credit event payment and the termination of the CDO. No equivalent counterparty risk
exists in a cash CDO, though default risk still lies with the reference assets. Cash CDOs also have a larger investor
base, because certain potential clients have limits on the use of credit derivatives.
For example, on an interest payment date, the CDO receives the premiums from the CDS, as well as the interest on
the high-quality, low-risk assets. The SPV then distributes the interest payments on each tranche according to its
risk level. Like a cash CDO, if a loss or default occurs, the payoff on the CDS is taken from the equity tranche first
(write-down of principal), with additional losses absorbed by the mezzanine tranche, and so on.

OTHER FIXED INCOME SECURITIES

Modern portfolios should also consider the benefits of recent or increasingly plentiful securities intended to help
reduce the risks that are present in the financial system. These risks include general economic cycle risk, currency
risk and interest rate risk due to inflation. Two opportunities that present themselves are investing in bonds issued
by foreign companies and governments or by domestic companies in foreign currencies, and in bonds whose returns
are linked to inflation.

FOREIGN CURRENCY INSTRUMENTS

The efficient frontier for fixed income securities is greatly improved in a mean-variance context by expanding the
universe of investable assets to include foreign securities. This can occur in a number of ways, but the real choice
depends on the portfolio’s goals. Given an imperfect correlation with international economic cycles, bonds of
foreign corporations will help diversify a portfolio to reduce total risk. Many foreign corporations will choose to issue
U.S. dollar–denominated bonds, while foreign-denominated bond issues abound. This raises the question of whether
such an investment adds to risk due to exchange rate risk.
There are two aspects to exchange rate risk. If the intent is for a bond portfolio to be part of a total portfolio that
includes equities, which these days are more than likely to have a foreign component, then foreign-denominated
bonds — or bonds issued by domestic or foreign corporations, or by governments offering diversification from
interest rate and currency risk — can help offset the equity portfolio’s risk. A detailed analysis of the correlations
between foreign returns, both before and after currency adjustments, is required to determine weights in both
the portfolio’s equity and fixed income components. If the portfolio owner is a corporation whose earnings were
affected by foreign sales or expenses, which is a less likely situation, then the bond portfolio could be used to hedge
those results. The other possibility is to use currency futures to hedge the payments from foreign-pay bonds.

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It should be noted that even for international bond portfolios, the question of currency risk hedging remains open.
There are proponents of currency risk hedging and those who maintain the opposite view. The latter feel that
currency risk is largely diversified in a broad portfolio of international bonds, and that hedging is a time-consuming
and costly process that is consequently not warranted. In fact, the opponents of hedging insist that currency risk is
desirable because it eventually hedges against the consumption effects of import prices.
Investing in foreign fixed income securities involves consideration of Eurodollar deposits and other similar short-
term vehicles denominated in different currencies and locations, as well as in Eurobonds and their equivalents. In
addition, more innovative instruments, such as dual currency bonds, which offer the holder the option to receive
payment in either of two currencies, create more possibilities that a bond portfolio manager must appraise. When
a portfolio manager is considering the purchase of more complicated instruments, they must consider not only the
issue of diversification and hedging of payment streams, but also the valuation of derivatives.

INFLATION HEDGING
Inflation has subsided from the double-digit annual rates of the 1970s. However, inflation exists and affects
investment choices. One consequence has been the issue of real return bonds, which are bonds that promise to
pay interest based on inflation levels. These bonds, effectively guarantee the preservation of purchasing power
to the holder. Both the interest payments and principal are linked to the change in the CPI. In considering these
bonds, a portfolio manager has to determine how the liabilities, if any, that are tied to the portfolio are affected
by inflation. There has been increasing criticism of the definition of the CPI as a measure of true inflation, which is
particularly relevant over a long time span.

USING DERIVATIVES IN FIXED INCOME MANAGEMENT

Futures on currencies, stock indexes and government bonds are standard instruments for the risk management
of foreign currency exposure and a portfolio’s inherent systematic risk. Swaps are a popular and effective means
of controlling the risk of holding or issuing debt. Interest rate futures and swaps are now essential tools in fixed
income portfolio management.

FORWARD RATE AGREEMENTS

A largely interbank market exists for forward rate agreements (FRAs), which are over-the-counter contracts
for hedging interest rates. The majority of these contracts are for six- to 12-month periods, with two years as the
longest life. Like many other financial derivatives, FRAs are settled by an exchange of cash to satisfy the closing
position with respect to the interest rate agreed on. Also, as FRAs strictly trade over the counter, no margin is
required between the parties.

EXAMPLE
For a bond portfolio manager, a bank might agree to fix an interest rate of 5.25% on a six-month deposit starting
in three months on a stated principal amount of $10 million. The party agreeing to fix the interest rate, which in
this case is the bank, is known as the FRA’s buyer. The bond portfolio, which is the party that wishes the interest
rate to be fixed, is known as the FRA’s seller. If in three months the going rate for six-month deposits is 5.5%,
the bond portfolio will settle the FRA by paying the differential of 0.25% × $10 million × 0.5 years to the bank.
The bond portfolio’s $10 million is then invested short term as desired at the current rate of 5.5%. The overall
effect is that the portfolio locks in a rate of 5.25%, having given up the chance to earn the higher rate by selling
the FRA. On the other hand, if the going rate in three months is 4.5%, the bank would settle the FRA by paying
the differential of 0.75% × $10 million × 0.5 years to the bond portfolio. Again, the bond portfolio’s $10 million
is invested as desired at the current rate of 4.5%, but the settlement of the FRA has the effect of increasing the
portfolio’s return to the locked-in rate of 5.25%.

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INTEREST RATE FUTURES

Interest rate futures, which are contracts used by banks, corporations and individuals to hedge interest rate risk for
future payments, are an alternative to using swaps.
Today, Canadian investors can hedge through the Bourse de Montréal (the Bourse) using three-month bankers’
acceptance (BA) futures or two-year, five-year, 10-year and 30-year GoC bond futures. U.S. futures exist for
Eurodollar deposits, treasury notes (medium-term bonds) and treasury bonds (long-term bonds). Futures also
exist for short-term Euro currency deposits based on the Euro Interbank Offered Rate (EURIBOR), and longer-
term German and U.K. government bonds. Canadian bond portfolio managers wanting to effectively hedge their
portfolios can use the Bourse’s instruments, but generally there will be much more liquidity on the U.S. exchanges.
U.S. futures will probably be needed, especially if a portfolio has any U.S. components, and European futures may be
used for European exposures.
The quotation, settlement and trading practices for individual instruments are likely to differ, and a familiarity with
the details is crucial to an understanding of futures strategies in bond hedging. The pricing of futures implicitly
determines the interest rate for the period covered. Naturally, the pricing is actually determined by the market’s
expectation of interest rates. For instance, Eurodollars and the Bourse’s BA futures are priced on an index basis, as
follows:
Futures price = 100 – the annualized discount yield (expressed in percentage form) (8.8)

EXAMPLE
A BA futures price of 94.60 means the futures are trading with an implied yield of 5.4%.

BA and Eurodollar futures are settled in cash with the final settlement price determined by market quotes (bids) for
the underlying instruments on the final day of futures trading.
Short-term futures are of interest to portfolio managers when a receipt of cash is anticipated in the near future. If
funds are due to be paid and a bond will be maturing before the actual payment date, the purchase of a BA futures
contract for or near the date of maturity allows the portfolio manager to ensure that the bond proceeds can be
invested at the short-term rate implied by the BA futures contract. The action will guard against a fall in short-term
rates before the bond’s maturity.
To illustrate, suppose a $5 million 8% bond will mature in 42 days — meaning that in 42 days the portfolio will
receive $5.2 million — at which point in time there is a period of up to 90 days before it will be reinvested. The
portfolio will have reinvestment risk during this 90-day period. To offset this risk, the manager can buy three-
month BA futures. Three-month BA futures that expire in 42 days are currently trading at 95.15, which implies
a yield of 4.85% (100 – 95.15) for the contract. The manager would have to purchase five $1 million contracts
to approximately cover their need to invest the $5.2 million. Falling rates will cause both the futures price and
the discounted BA price in 42 days to rise, with the futures gain roughly offsetting the opportunity cost in future
interest lost.
Bond futures on U.S. and GoC bonds are based on notional bonds whose prices depend on changing rates for their
maturities. For the GOC 10-year bond futures contract, the reference bond is a 10-year 6% coupon bond. Both
Canadian and U.S. bond and note futures are settled by delivery of one of a range of acceptable bonds at a chosen
date, with both uncertainties determined by the party that is short the contract. The bond portfolio manager’s
recognition of these and other issues, such as conversion factors and the cheapest-to-deliver bond, which are beyond
the scope of this course, is essential when engaging in a hedge portfolio using these futures. Also, marking to market 3
has only a minor effect on cash flows, but the cash must be available as needed for possible margin calls.

3
The process in a futures market in which the daily price changes are paid by the parties incurring losses to the parties earning profits.

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The more common problem is to hedge the value of a portfolio or an individual bond against long-term rate
increases. The sale of bond futures will cause gains on the futures position through a rate increase to compensate
for the portfolio’s resulting loss, and vice versa. There are two aspects to the risk, with one being volatility in the
portfolio value and the other being loss of value.
The first problem is solved by setting as an objective the minimization of the variance in the portfolio’s value, as
hedged by the futures position. The important detail about using futures as a hedging technique is determining the
hedge ratio, which is the relative number of derivative contracts per underlying asset necessary to protect against
changes in the portfolio’s value. This can be determined by regressing the changes in cash prices against those in
futures prices. A simple linear regression would reveal the hedge ratio as the slope. Since linear regression minimizes
the sum of the squares of the error term, it effects a variance minimization. The input data are historical bond
prices and the chosen futures contract, where the bonds should be chosen to represent the portfolio’s holdings.
Multiplying the hedge ratio times the face value of the portfolio and dividing by the face value of the contract yields
the number of contracts to use in the hedge.
The alternative approach is to hedge the portfolio’s value by considering its modified duration. Essentially, the
modified duration, price and face value of the contract and portfolio are compared to determine the hedge ratio.
The formula is as follows:
MVp DP (8.9)
Hedge Ratio = ´
MVF DF

Where:
MVP = The portfolio’s market value
MVF = The futures contract’s market value
DP = The portfolio’s modified duration
DF = The futures contract’s modified duration

Hedging with the number of contracts calculated using formula 8.9 effectively changes a portfolio’s duration to
zero, thereby insulating it from any changes in the interest rate — good or bad.

EXAMPLE
Consider a portfolio with a market value of $110 million and a modified duration of 9.55 that is hedged with 10-
year GoC bond futures with a market value of $104,000 and a modified duration of 5.85. The portfolio manager
would sell the following:
$110,000,000 9.55
Hedge Ratio = ´ = 1,727 contracts
$104,000 5.85

Note that in the example above, the portfolio can also be hedged by a combination of longer and shorter futures
contracts for which separate hedge ratios would be needed, determined by the proportion of the portfolio to be
hedged by each futures position.
Hedging with futures still entails risk. The basis refers to the difference between the futures price and the spot
price, which is the actual price of a commodity or underlying asset to a futures contract on the current day. At the
maturity of a futures contract, the basis must equal zero. If the basis is not zero, arbitrage profits are possible.
Basis risk is the risk that the basis will not behave as expected over the life of the hedge. If a hedge needs to be
lifted prior to the maturity of the futures contract, any unexpected shift in the basis has the potential to reduce the
effectiveness of the hedge. The more the notional bond underlying the futures contract differs from the portfolio’s

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bonds, the more the basis risk affects the hedge. Also, as the contract matures and the spot and futures prices
converge, the hedge position will change in value more directly with interest rate changes. While the fundamental
interest rate risk is largely controlled through the hedge, the basis risk can be lowered by under-hedging the
position.
The hedge ratio formula shown in the example above can be rearranged to provide the number of contracts needed
to adjust a portfolio to any duration. The rearranged formula is as follows:

MVp (DT - D1 )
Hedge Ratio = ´ (8.10)
MVF DF

Where:
DT = The portfolio’s target modified duration
DI = The portfolio’s initial modified duration

EXAMPLE
Hedging a Bond Portfolio Against Interest Rate Risk
A fixed income manager is anticipating a sharp increase in interest rates immediately following the next U.S.
inflation report. As a temporary strategic measure, the manager intends to reduce her portfolio’s modified
duration to one-half of its current level. Further, she notes that the portfolio’s duration will be readjusted back to
normal levels one week after the inflation report.
The portfolio is a $50 million corporate bond portfolio consisting of 50 investment-grade bond issues. The
manager calculates that the portfolio’s modified duration is currently five years. She estimates that she would
have to switch approximately $25 million of her mid- to long-term bonds for T-bills in order to meet the
portfolio’s modified duration target of 2.5 years. Using an average bid-ask spread estimate of 0.25% of market
value for corporate bonds, the manager estimates that her expected round-trip transaction costs for these
duration adjustments would be 0.25% of $25 million, or approximately $62,500.
The manager is concerned with the high transaction cost and the fact that these trades temporarily lower
the portfolio’s corporate credit risk exposure. If corporate bonds perform well in the interim, the manager’s
performance will lag fully invested corporate bond portfolios. As an alternative, the manager considers selling
GoC bond futures to lower the portfolio’s overall modified duration by fully hedging exactly half of its market
value. The manager calculates the modified duration and market value of the 10-year GoC bond futures contract
to be 6.4 and $95,000, respectively, and uses these figures to determine the number of contracts required
to lower the portfolio’s total modified duration to 2.5 years. Using Equation 8.10, she makes the following
calculations:

$50,000,000 (2.5 - 5)
´ = -206
$95,000 6.4
The number of futures contracts the manager will have to sell, then buy back again later, is 206.
Finally, the manager estimates that the round-trip bid-ask spread is $100 dollars per contract and round-
trip brokerage commissions are $25 per contract. This implies that the total expected transaction costs from
implementing these duration adjustments using futures would be $25,750 [206 × ($100 + $25)]. The manager
decides to reduce the portfolio’s duration by selling 206 10-year GoC futures contracts. She recognizes that while
this minimizes the expected transaction costs and maintains full corporate credit risk exposure, it also introduces
basis risk into the portfolio.

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INTEREST RATE SWAPS

Interest rate swaps are agreements made between two parties to exchange interest payments on loans for the
same amount. Each party guarantees to pay the other’s interest for a stated period, allowing portfolio managers
to react to anticipated rate changes without having to perform a major and costly restructuring of their portfolio
through the sale of its various components and the substitution of others. In dealing with swaps, there are two
established assumptions. First, the short-term rate used in U.S.-dollar swaps is conventionally the London Interbank
Offered Rate (LIBOR) used for European market interest rates and as a base for many international lending
contracts. The rate conventionally used in Canadian-dollar swaps is the Canadian Dealer Offered Rate (CDOR),
which is an average BA rate. The LIBOR is a floating rate, unlike U.S. or Canadian T-bill rates, which are fixed. Second,
the underlying principal to which rates apply is a notional principal only — that is, it is not actually exchanged.

EXAMPLE
Plain Vanilla Swap
The plain vanilla swap is the most common and basic swap. One side pays a fixed-rate cash flow and the other
side pays a floating-rate cash flow. To illustrate, consider a bond portfolio with a duration of 10 years, designed in
response to a portfolio manager’s expectation of stable rates. At this point, the manager has decided that rates
will finally rise and wishes to guard against this by shifting $50 million out of 20-year 6.5% bonds, which are
currently trading at par, into 364-day T-bills with a 5% yield. The manager enters the swap market and offers to
swap interest payments at 6.5% for receipt of interest payments at the LIBOR, based on the notional principal
of $50 million. The portfolio will then receive an annual rate of the LIBOR × $50 million in exchange for paying
6.5% × $50 million, or $3.25 million, with interest being received at 6.5% on the portfolio’s bonds. If the LIBOR
remains at the T-bill rate plus 1%, and the T-bill yields are either of 5%, 5.5% or 6%, the portfolio’s net cash flow
will be the following:
T-Bill Rate
Cash Flow ($ Million) 5% 5.5% 6%
T-Bond Interest $3.25 $3.25 $3.25
Swap Cash Flow
6.5% Bonds ($3.25) ($3.25) ($3.25)
LIBOR $3.00 $3.25 $3.50
Net Cash Flow* $3.00 $3.25 $3.50

* For example, for the 5% T-bill rate scenario, the portfolio receives $3.25 million in interest from the T-bonds it owns. It pays $3.25 million
as part of the swap. In addition, the portfolio receives $3 million as part of the swap. By adding up these three numbers, we arrive at a
net cash flow of $3 million, which is an inflow of $3 million and therefore a positive number.

The swap agreement commits to an exchange of payments on the notional principal over a period of time. Instead
of rolling over the T-bills every year, the LIBOR is received at an anticipated rising yield. Assume that the swap has
been taken for three years. Over that time, the portfolio will continue to hold the bonds and use their coupon to
make the swap payments against the LIBOR. The terms of the swap are likely to be that LIBOR, as of the beginning
of each annual period, will be the rate at which interest is determined for the period. This will then closely track the
T-bill rate that could have been gained.
The example above illustrates the substitution of a variable flow of $3 to $3.5 million for a fixed rate of $3.25
million. In reality, the LIBOR is likely to be closer to the T-bill rate, so the cash flow may be worse by comparison.
Swap markets are not really composed of individual participants searching for others to take the other side. Usually,
swaps are brokered by a dealer who maintains a swap book with potential rates for fixed- and floating-rate loans.
Individual swaps are arranged through the dealer, who charges a fee based on the interest rate differentials going

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either or both ways, as illustrated in Figure 8.9. At times, the dealer may take one side of the swap, expecting to re-
swap the other side in the near future.

Figure 8.9 | Interest Rate Swap with a Dealer

Floating Rate
(LIBOR) LIBOR LIBOR
Counterparty Dealer Counterparty
A B
6.25% 6.5% 6.5%
Fixed Rate

Although generally bond futures are a more effective instrument for hedging a portfolio’s holdings, for bond
portfolios, the major advantage of a swap arrangement is the ability to modify the lending terms in response to
anticipated interest rate changes, without having to incur the transaction costs of buying and selling securities. The
market is extremely liquid, with volumes in the trillions of dollars, matching portfolio holders and borrowers that
choose to swap their borrowing terms to more suitable ones versus their corporate cash flows. Swaps are usually
illustrated with examples of borrowers that are seeking more favourable terms.
The question always arises as to why borrowers choose to swap instead of arranging more suitable loans in the first
place. The standard answer is that they have greater capacity to borrow short or long, in one market or another,
than they do to borrow the alternative that they prefer. This refers to reputation and credit risk. The conclusion is
that either the credit market is inefficient in determining risk due to a lack of information, or the swap market is
inefficient and is exposing participants to more risk than they realize. It is crucial to realize that swaps are a binding
agreement on both parties, but that defaults can occur. In such cases, it is more often the beneficiary of an ex-post
favourable swap who finds the loser in default than the reverse.

CREDIT DERIVATIVES
Credit derivatives are financial instruments that derive their value from an underlying credit asset or pool of credit
assets, such as bonds or mortgages, and are designed to transfer and manage credit risk. The underlying asset being
protected is the reference asset, which is issued by the reference entity. The payouts are a function of an issuer’s
creditworthiness. In essence, credit derivatives offer credit holders or speculators a way to make an investment
decision based on an issuer’s credit risk that is separate from the investment decisions they make based on other
risks, such as duration and currency.
Credit derivatives allow market participants to fine-tune the credit risk exposures associated with their credit
portfolios. Credit assets represent a sizeable proportion of the portfolios held by banks, portfolio management
companies, insurance firms and hedge funds. In a context of significantly increased credit market volatility, credit
derivatives have become extremely popular. In fact, they are the fastest-growing segment of the market.

THE ROLE OF CREDIT DERIVATIVES

The basic objective of credit derivatives is to transfer credit risk between the protection buyer, the party wishing
to reduce credit risk, and the protection seller, the party wishing to acquire credit risk. It is understood that the
protection seller has gone long the credit and the protection buyer has gone short the credit.
Credit derivatives transfer credit risk in the following two ways:
1. By diversifying a bond portfolio: A bank or fixed income portfolio manager may want to assume credit risk by
providing credit protection in return for a fee. Doing so increases a portfolio’s yield and also enables the bank
or fixed-income manager to gain credit exposure for clients who are unwilling or unable to purchase the bonds
directly.

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2. By reducing credit risk: A bank or fixed income portfolio manager may want to reduce credit risk for a single
reference asset or an entire sector by buying a credit derivative.

Credit derivatives have certain inherent advantages that allow portfolio managers to accomplish this objective
more efficiently than with physical fixed income assets. First, credit derivatives separate the credit risk decision from
the duration and liquidity decisions. Typically, all the risks inherent in a physical bond are bundled and cannot be
separated on purchase. With credit derivatives, the manager can take credit risk without assuming the liquidity and
duration risks of holding the reference asset. This feature also allows the manager of the reference asset to keep
a portfolio’s holdings intact. Without credit derivatives, a manager who is worried about a portfolio’s short-term
credit would be forced to sell their assets, thereby incurring a tax liability.
Second, a credit can be sold short easily using a credit derivative. In the physical bond market, it is extremely
difficult, if not impossible, to sell short a bond or bank loan in the same manner as a stock. Economically, the credit
derivative accomplishes the same effect synthetically.
Finally, when embedded in structured products, such as CDOs, credit derivatives give investors synthetic exposure
to certain assets without the stress of administering them. For example, a bank could bundle its industrial loans and
sell off the credit risk using credit derivatives. The investor benefits from the higher-than-average yield and the bank
benefits by reducing the credit risk on its loan portfolio.
Different institutional investors have different uses for credit derivatives, as shown in Table 8.5.

Table 8.5 | Purpose of Credit Derivatives

Holder Buy Sell

Banks They use credit derivatives to hedge and They also sell protection to diversify their
therefore buy protection from counterparties. loan portfolios — changing their return-
They do so for the following reasons: risk profiles — and enhance yields with
respect to lending. The credit derivatives
• To enhance their credit risk management
add income to the returns generated by
by decoupling the credit positions from
the portfolios themselves, a situation
their risk profile
that is somewhat analogous to covered
• To retain ownership of loans, given their call writing with equities.
increased risk level
• To reduce regulatory capital requirements
by reducing the risk budget proportion
attributable to the portfolio’s credit
component

Insurance Similar to banks, they buy and sell protection, They may sell protection to increase
Companies depending on circumstances and their yields, which is once again analogous
portfolio make-up. They typically buy to covered call selling with equities,
protection to diversify and mitigate liability and to help match assets to liabilities,
concentrations, in effect selling away the particularly to match cash flows from
risks associated with concentrated liability one to the other.
commitments, rather than reconfiguring their
liability portfolios, which may prove difficult.

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Table 8.5 | Purpose of Credit Derivatives

Holder Buy Sell

Asset Managers They buy protection to manage negative As other market participants do, they sell
and Hedge Fund expectations on positions for macroeconomic protection for the following reasons:
Managers or sectoral reasons. They may also establish
• To increase yield and diversification,
forward long or short trades to access these
given a positive credit outlook
markets, mainly as hedgers.
• To generate leverage on existing
portfolios
• To establish forward trades — long or
short — mainly as speculators

Securities Dealers They buy protection to cover their exposure They sell protection to increase yield,
as market makers and, more generally, to better diversify their loan and asset
manage the credit risk on their books. portfolio, and help offset hedging costs
for other credits.

Source: Celent Communications, Asset Counsel Inc.

THE STRUCTURE OF CREDIT DEFAULT SWAPS

Of the several forms of credit derivatives in the marketplace, the most basic form is the credit default swap (CDS).
A CDS is the exchange of two cash flows: a fee payment and a conditional payment, which are only made if a credit
event occurs. A credit event is defined as:
• A downgrade in credit rating below a specified level
• Financial or debt restructuring
• Bankruptcy or insolvency of the reference asset obligor
• A default on a payment obligation, such as a bond coupon, and continued non-payment for a specified period
• A technical default, which is a non-payment of coupon or interest when due

Even if only one of these conditions is met, a CDS will have value for the protection buyer, whereas the protection
seller will keep the predetermined fee regardless of the outcome — positive or negative — for the obligor.
A CDS is analogous to a specific type of insurance option in which the default of an asset triggers payment. One
party buys the protection and insures itself against the risk of default or other credit impairment on an underlying
credit instrument, whereas the other party accepts the risk of an uncertain event in exchange for a fee. The
protection buyer holds a risky asset and pays a reasonable fee (premium) to reduce the severity of possible adverse
outcomes. The protection seller values the premium’s cash flows against the risk of adverse outcomes and possible
payouts. Figure 8.10 shows the structure of a single-name (or single-asset) CDS.

Figure 8.10 | Cash Flows of a Single-Name CDS

Protection fee (premium)

Protection
buyer/owner of Protection
underlying asset seller
Payment made only if credit event
on underlying asset occurs

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If a credit event occurs, the CDS is activated and terminates with the payment according to the contract’s
predetermined conditions. The payment can be 100% of the face value or a percentage of the total (nominal) CDS
commitment, depending on the importance of the loss triggered by the credit event. There are two payment modes,
as follows:
• Physical settlement: The protection buyer remits the asset to the protection seller against the full face value
payment.
• Cash settlement: The protection buyer retains the asset and receives the difference between the face value and
recovery value.

Based on Figure 8.10, consider the following situation: On August 15, 2017, two parties enter into a CDS. The terms
of the contract are a five-year CDS, with the protection buyer paying 120 basis points (bps) annually for protection
on a $100 million bond position (reference asset). The contract’s payment schedule calls for semi-annual payments
with physical delivery of the bonds in the event of default. The protection buyer pays $600,000 every six months
to the seller [(120 bps × $100 million) ÷ 2] beginning on February 15, 2018, until the end of the contract or until the
credit event (default) occurs. The buyer will only receive a payout if the reference entity defaults, thus triggering the
credit event. If this happens, the protection seller must buy the bonds for $100 million.
If this situation called for cash settlement rather than physical settlement, the recovery value would be determined
by an independent assessor using the recovery rate, which is the realizable rate of recovery upon default. If the
bonds’ recovery rate is $200 per $1,000 of par value (20%) after the default, the cash payout the protection seller
must make is $80 million ($100 million – $20 million recovery value).
Each payment method offers certain advantages. Physical settlement is preferable for the protection seller if the
fortunes of the asset’s issuer improve. Physical settlement also permits the protection seller to take part in creditor
negotiations with the reference asset’s issuers, which may result in improved terms for them. Cash settlement is
administratively simpler than physical settlement and preferable when the credit derivative is part of a synthetic
structured product. Also, cash settlement does not expose the protection buyer to shortages of the underlying
deliverable asset.

ADVANTAGES AND DISADVANTAGES OF SECURITIZATION

Securitization — cash CDOs, synthetic CDOs or ABS — gives a loan originator certain advantages, as follows:
1. The potential for reduced funding costs: Through securitization, a company can issue debt that is de-linked
from its own credit ratings, and can therefore often achieve a lower cost of funds for its operations.
2. The protection of underlying assets: If the loan originator that issued the bonds using the assets as collateral
later goes bankrupt, creditors can go after the receivables for recourse. For example, under an SPV structure
of a cash CDO or ABS, the SPV owns the receivables and creditors cannot go after the assets because the SPV
legally owns them.
3. The diversification of funding sources: Loan originators can construct a more cost-efficient capital structure by
employing securitization instead of more conventional funding sources, such as bank loans or corporate debt.
Securitization also typically lacks restrictive covenants that often accompany bank loans or corporate debt.
4. The acceleration of earnings for financial reporting purposes: The loan originators can immediately book
the proceeds from the sale of the receivables as income, less the servicing costs and coupon payments to
investors. The proceeds can go straight to the bottom line instead of as a figure on the asset side of the
statement of financial position.

The two biggest disadvantages to securitization are the following:

1. The lack of transparency of the underlying assets
2. The pricing of the securitization

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First, the lack of transparency of the underlying assets makes it difficult for credit analysts to gauge a proper credit
rating on the securitization. Bad credit risks could easily hide in a pool of assets. Creating a large pool is supposed
to mitigate the risk through diversification, but a pool containing a large number of credit risks could easily be
overlooked.
Second, at the best of times, a CDO and ABS are extremely difficult to price. As the credit crisis of 2007 revealed,
money market funds that held these instruments had a great deal of trouble valuing them. The assets that
supported the cash flows were often mortgages granted to individuals with poor credit who were buying overvalued
homes in the U.S. As the underlying cash flows dried up, the value of the securitized instruments suddenly came into
question. No one knew how to place a definitive value on the securities. Investor demand for new paper disappeared
because of the pricing uncertainty, and holders of the paper could not find buyers.

HIGH-YIELD (JUNK) BONDS

A high-yield bond, which is commonly known as a junk bond, is a bond that currently has a non-investment-grade
credit quality rating from one or more bond credit-rating agencies. Non-investment-grade bonds have credit ratings
of Ba1/BB+ or lower. Conversely, investment-grade bonds have current credit ratings of Baa3/BBB- or higher.
The origin of the term junk bond is unclear, but it likely surfaced when the high-yield bond market was in its infancy.
The prevailing view was that a bond with a non-investment-grade credit rating was likely doomed to fail because of
its issuer’s insolvency. Therefore, market observers considered them to be fit only for the garbage bin, thus the term
junk bond.

HIGH-YIELD BOND ISSUERS

The two major issuers of high-yield bonds are original issuers and so-called fallen angels, as described below:
• An original issuer is a bond issuer with a non-investment-grade credit rating at the time of underwriting. A non-
investment grade is typically assigned to new issue bonds for one or more of the following reasons:
The issuer is highly leveraged relative to its immediate competitors or typically for its industry.
The issuer has no demonstrable operating track record, but has above average growth and profitability
prospects. For example, it may be a start-up company in an emerging and potentially profitable industry.
The issuer is currently experiencing financial difficulties, but does not have any bonds presently outstanding.
• A so-called fallen angel is a bond issuer that once had an investment-grade credit rating on its bonds
outstanding, but has recently fallen into financial difficulty. As a result, the issuer’s bonds outstanding have
been downgraded to a non-investment-grade rating. Fallen angels can be either in or on a path to bankruptcy.
Certain institutional investors in high-yield bonds specifically target fallen angels for their potential investment
value. They purchase downgraded securities that are in either reorganization or liquidation, depending on
whether the issuer is near bankruptcy or in bankruptcy court protection.

Some industry commentators believe a third source of high-yield bonds exists: those issued by either the acquiring
entity or the target company of a leveraged buyout (LBO). In an LBO, the target company, which is either
public or private, is bought out by a limited group of investors. If the investors are the target company’s current
management, the transaction is called a management buyout (MBO). If the investors are a firm specializing in LBOs,
the transaction is called a leveraged buyout. The name is derived from the fact that the firm must typically issue a
large number of bonds to finance the purchase of the current shareholders’ holdings. Firms that specialize in LBOs
do so in the hope of reorganizing the target firm and eventually selling it at a profit. In many cases, the degree of
leverage is so high that the newly issued bonds can only garner a non-investment-grade credit rating at the time of
underwriting.

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HIGH-YIELD BOND INVESTORS

Individuals rarely invest directly in high-yield bonds. Instead, they gain indirect exposure to them by investing in
managed financial products.
The clear majority of outstanding high-yield bond issues are held by institutional investors. Because of the inherent
credit risk and complexity of high-yield bonds, there are at least two factors for successfully investing in them:
• Investors must conduct a proper and detailed fundamental analysis on high-yield bonds and their respective
issuers.
• Investors must diversify their holdings to compensate for the risks associated with individual bond issues.

Understandably, institutional investors are in the best position to deal with the requisite success factors.
As of June 2016, the market value of the U.S. high-yield bond sector was approximately US$1.61 trillion. Its
institutional ownership distribution at the time is shown in Table 8.6.

Table 8.6 | U.S. High-Yield Bond Sector as of June 2016

Type of Institutional Investor Share of Total High-Yield Market (%)

Life Insurance Companies 28.6
High-Yield Mutual Funds 27.2
Pension Funds 26.3
Hedge Funds 8.2
Investment-Grade Bond Mutual Funds and Exchange- 6.2
Traded Funds (ETFs)
Equity and Fixed Income Mutual Funds 3.5

HIGH-YIELD BOND MARKET INDEXES

Like all well-developed financial markets and investment sectors, the U.S. high-yield bond market has several well-
designed indexes, which are useful tools for measuring the performance of a fund or fund manager. These indexes
also support fund design, regulatory oversight and academic research, all of which, in turn, support the growing
interest and investment in the high-yield bond sector.
Four U.S. high-yield bond market indexes are as follows:
• Merrill Lynch High Yield Master II Index
• CSFB High Yield II Index
• Citigroup U.S. High-Yield Market Index
• Barclays High-Yield Index

Although they are related, each index has a unique construction methodology. All four indexes attempt to mimic
the overall U.S. high-yield bond market with respect to the following parameters:
• Market value weighting exposure of an economic/industry sector
• Maximum percentage index weighting exposure per chosen issuer
• Average credit rating for the market, and credit rating distribution by economic/industry sector
• Average term to maturity for the market, and term-to-maturity profile

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• Average coupon rate for the market and for an economic/industry sector
• Structure profile (convertible, step-up, fixed/floating, payment-in-kind, etc.)

Indexes are also available for certain credit rating sub-sectors of the high-yield bond market. For example, some
investors may wish to direct or restrict their high-yield investment allocation funds to the higher-quality portion of
the high-yield bond market. These investors will likely select a high-yield bond market index that limits its exposure
to only BB-rated and B-rated securities. One such index is the Merrill Lynch Global High Yield BB-B Rated Index.
Likewise, investors who seek a higher amount of credit risk might choose high-yield bond market sub-indexes for
CCC/Caa- or lower-rated securities.

CREDIT RATING METHODOLOGY

The three main global bond credit-rating agencies are Moody’s Investor Service (Moody’s), Standard & Poor’s
Financial Services LLC (S&P), and Fitch Ratings Inc. (Fitch). Collectively, they currently have a nearly 95% global
market share.
The bond credit-rating agencies assign a unique grade or credit rating to a bond based on their respective
assessment of the issuer’s ability to make timely interest and principal payments during the life of the bond.
Essentially, bond credit ratings attempt to provide objective, consistent and simple measures of a bond issuer’s
creditworthiness. These credit ratings are opinions of a bond issuer’s future creditworthiness relative to other
issuers.
Credit-rating agencies employ fundamental credit analysis to develop their credit ratings. In the case of Moody’s,
its fundamental credit analysis focuses on four main aspects of both the bond issuer and the bond issue under
examination, as follows:
1. Fundamental analysis – Moody’s fundamental analysis of a bond issuer focuses on four main traditional groups
of financial statement analysis:
Leverage
Asset/collateral coverage
Liquidity
Profitability

Moody’s analysis also includes the following factors:

Industry trends
Regulatory environment
Competitive position
Access to liquidity (capital markets, bank lines)
Issuer structure (priority of claim, structural subordination, support agreements)
Special event risk

2. Covenants – Analysis in this area focuses on the following:

Restrictions on an issuer’s activities
Affirmative covenants and negative covenants
Appropriateness and applicability to an issuer’s industry
“Need to be tight, but not too tight”

3. Franchise/collateral value – Moody’s estimates a bond issuer’s franchise value on a going concern basis. This
calculation depends heavily on an issuer’s competitiveness ranking within its industry. It also depends on

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an issuer’s ability to both grow profitably at a faster rate than its competitors and, conversely, its ability to
survive during periods of economic or industry downturn. The estimate of an issuer’s franchise value also
drives the calculation of asset/collateral coverage. In the event of an issuer’s bankruptcy, this calculation aids
bondholders that may need to sell some or all of an issuer’s assets to recover amounts due to them as lenders.
4. Management quality – Analysis in this area focuses on an issuer’s operating philosophy, operating track record,
strategic planning and ability to react successfully to unexpected changes.

Essentially, the credit-rating process focuses on forming views regarding the likelihood of plausible future outcomes.
It does not forecast scenarios; instead, it places some weight on their likely occurrence and on the potential credit
consequences.
Bond credit ratings for the three main bond credit-rating agencies are compared and briefly described in Table 8.7.

Table 8.7 | Bond Credit Ratings

Rating Grade Description

Fitch S&P Moody’s (Moody’s)
AAA AAA Aaa Minimal credit risk
AA+ AA+ Aa1
AA AA Aa2 Very low credit risk

Investment grade
AA- AA- Aa3
A+ A+ A1
A A A2 Low credit risk
A- A- A3
BBB+ BBB+ Baa1
BBB BBB Baa2 Moderate credit Risk
BBB- BBB- Baa3
BB+ BB+ Ba1
BB BB Ba2 Substantial credit risk
BB- BB- Ba3
B+ B+ B1
B B B2 High credit risk
(non-investment grade)
Speculative grade

B- B- B3
CCC+ CCC+ Caa1
CCC CCC Caa2 Very high credit risk
CCC- CCC- Caa3
CC CC Ca In or near default, with
C C – possibility of recovery

DDD SD C
In default, with little
DD D –
chance of recovery
D – –

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DEFAULT RISK AND DEFAULT RATES

A key metric for estimating default risk in the high-yield bond market is the default rate over various time periods.
Defaults are defined as bond issues where one of the following events has occurred:
• A missed payment of interest and/or principal due has not been paid within the normal 30-day grace period
• The issuer has filed for bankruptcy protection or liquidation
• A corporate restructuring has been announced

There are two main types of default rates, as follows:

• Dollar-denominated default rate, which is based on the dollar amount of bonds that have defaulted
• Issuer-denominated default rate, which is based on the number of issuers that have defaulted

Both types exhibit a high correlation over long periods, but can greatly diverge over short periods. The dollar-
denominated default rate is more popular, but there are specific instances or types of analysis where the issuer-
denominated default rate is more applicable.
Figure 8.11 shows the trailing 12-month default rate (%) for U.S. corporate high-yield bonds since 1920.

Figure 8.11 | Default Rate (%) for U.S. Corporate High-Yield Bonds

20%
18%
Trailing 12-Month Default Rate

16%
14%
12%
10%
8%
6%
4%
2%
0%
00

05
40

80
60

90

10
30

50
20

45

85
65

95

15
35

55
25

70

75

20

20

20

20
19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

Legend:
NBER-Dated Recession
U.S. Corporate Default rate

Source: Moody’s Analytics Default & Recovery Database

The following three main conclusions can be gathered from this long-term graph:
1. Not surprisingly, the rate of corporate bond default rates increased during periods of economic stress, defined
as the U.S.-based National Bureau of Economic Research (NBER) recession periods.
2. At least when measured in terms of U.S. corporate bond default rates, the depth or severity of the 2008
Financial Crisis was at a level not seen in the U.S. since the Great Depression of the 1930s.
3. The default rates of U.S. high-yield bonds have declined markedly since the Financial Crisis of 2008.

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RECOVERY RATES
When the default rate is used to measure credit risk, it is calculated at the time of the credit event. If calculated on
a dollar-denominated basis, it reveals the amount of a lender’s funds that are at risk of non-repayment given the
worst-case scenario.
However, only in a limited number of situations does the actual monetary loss equate to the original default
amount. In most situations, lenders recover some of their security’s value. The amount of value/funds eventually
realized by creditors as a percentage of the bond’s face or default amount is called the recovery rate.
Of course, lenders attempt to maximize the recovery rate on their defaulted bonds. This goal dictates the
negotiating strategy they employ with the borrower prior to bankruptcy proceedings. The amount eventually
recovered — and therefore the recovery rate — depends on several factors, including the issuer’s collateral value and
the general state of its industry and of capital markets.
Depending on the issuer’s size and complexity, as well as the factors noted above, it can often take a year or two for
bondholders to reach a final resolution of their claims.

CREDIT SPREAD
As compensation for assuming credit risk, lenders require an incentive to purchase corporate bonds, both at the
time of bond underwriting and in secondary market trading, in the form of a higher yield. This so-called credit
premium is calculated as the difference between the yield to maturity (YTM) of the corporate bond minus the YTM
of a federal government bond of the same maturity.
All else being equal, the lower the bond’s perceived credit risk, the higher its credit rating and the smaller, or tighter,
the yield spread will be.
Primarily because of their inherent higher degree of leverage, the credit spreads of high-yield bonds will generally
react quickly to credit-rating upgrades or downgrades and to corporate announcements that suggest a change in
the issuer’s creditworthiness.

UNIQUE COUPON STRUCTURES

Similar to investment grade-bonds, most high-yield bonds have fixed coupon payments over the life of the security.
However, the high-yield bond market has a higher percentage of bonds outstanding with call features, when
compared to the percentage share of the investment-grade bond market. High-yield bond issuers generally want
the flexibility to call coupon debt outstanding should bond market conditions improve and permit lower-cost
refunding.
In addition, the high-yield bond market has some unique coupon structures that are seldom used when
underwriting investment-grade bonds. These structures are primarily driven by the need for the issuer to conserve
cash, especially during the immediate years after the bonds are issued.
These coupon structures are often considered when underwriting high-yield bonds to finance two types of
transactions, as follows:
1. LBOs and MBOs: These types of merger and acquisition (M&A) transactions often involve the assumption of a
very high degree of leverage by the target company. In turn, high leverage puts a high strain on the company’s
cash flow, especially shortly after its acquisition. In buyout situations, the cash flow from operations is likely to
be insufficient to cover coupon payments in the short term.
2. Start-ups: A bond issuer looking to fund either a start-up facility or an incremental capital expansion requires a
substantial amount of capital. Without having a current at-scale operating facility, the issuer is unlikely to have
the cash flow available to pay cash coupons until the plant is fully operational.

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The suitable debt financing solution for these types of transactions is to pay little or no cash coupons on the bonds
in the short term. Then, at some point in the intermediate future, the bonds begin to pay a cash coupon that is
higher than current market yield. In both cases, the lenders want the debt financing to be consistent with their
business plans. This usually involves the implementation of an efficiency program and/or an incremental capacity
expansion program that results in sufficient positive free cash flows at a set point in the future — often two to three
years — to service the debt.
The coupon structures most frequently used by high-yield bond issuers with the goal of short-term cash
conservation are deferred coupon bonds, extendible reset bonds and payment-in-kind (PIK) bonds:

Deferred Coupon The issuer pays no interest for a set number of years — usually two to four years —
Bonds immediately after the issuance, then pays cash coupons until maturity at an agreed upon
interest rate at the time of underwriting. The cash coupon is deliberately negotiated at
an above-market interest rate to compensate the lender for the both the value of the
initial coupon deferment and the credit risks associated with the issuer.
An iteration of a deferred coupon bond is a step-up bond, which is underwritten with
pre-defined (varying) coupon rates for each year until maturity. The coupon rate is set
below market for the first few years, but then crosses to above-market rates for the
remainder of the bond’s term.

Extendable Reset These bonds permit the issuer to reset the coupon rate at a fixed date in the future so
Bonds that the bond will then trade at a set market price, which is usually at par. With some
issues, rates can be reset quarterly or annually, but most issues permit only one coupon
reset date during the life of the bond.

Payment-in-Kind (PIK) These bonds provide the issuer with the option to pay coupons on their payment date in
Bonds one of the following two methods:
• Cash
• An identical bond to the original PIK issue in an amount equal to the coupon’s value
The issuer normally has this option for approximately the first half of the original PIK
bond’s life. After that point, the coupon can only be paid in cash.

FIXED INCOME EXCHANGE-TRADED FUNDS (ETFs)

Consistent with the overall Canadian exchange-traded fund (ETF) market, Canadian fixed income-related ETFs have
experienced phenomenal growth over the past decade.
Industry monitors4 report that Canadian fixed income ETFs had $33.8 billion in AUM as of December 31, 2016.
This amount corresponds to 29.7% of the total Canadian ETF industry’s assets. Furthermore, five fixed income ETFs
ranked in the top 10 Canadian ETFs by fund AUM as of December 31, 2016.
In terms of specific investment mandates, the total AUM for Canadian fixed income ETFs of $33.8 billion as of
December 31, 2016, is distributed as per Table 8.8.

4
Canadian ETF Association, Canadian ETF Assets as at December 31, 2016 report dated January 18, 2017.

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Table 8.8 | The Canadian Fixed Income ETF Market

Fixed Income AUM Share of Total Canadian Fixed Income ETF AUM
Investment Mandate ($ Billions) (Percentage)
Investment Grade 30.4 90
Corporate 13.4 40
Government 5.7 17
Mix 11.3 33
High Yield 3.4 10
Corporate 3.0 9
Emerging Markets 0.2 <1
Mix 0.2 <1

INVESTMENT MANDATES FOR FIXED INCOME ETFs

The Canadian fixed income ETF market offers investors customized exposures to many types of fixed income
securities that are traded on domestic and international bond and money markets. This well-developed market
allows investors and their investment advisors to structure their fixed income ETF portfolios precisely to meet their
needs and risk tolerance level.
Like other types of ETFs, fixed income ETFs are normally structured to track or replicate a passive investment
benchmark. This benchmark is usually chosen from one of two main forms, as follows:
1. A standardized fixed income benchmark that is often quoted in the financial press and that many investors are
familiar with.
2. A customized benchmark that includes a unique passive fixed income portfolio designed by an ETF manager.

After selecting a performance benchmark, an ETF manager’s next step is to create a set of unique investment
guidelines and restrictions. This step ensures that the ETF’s assets are invested and managed in a manner that allows
the fund to meet its respective performance benchmark.
The performance benchmark of an ETF and its respective investment guidelines and restrictions are chosen with the
following three main factors in mind:
1. Interest rate risk (also called market risk)
This is generally the single largest risk to a fixed income portfolio, as it is directly related to the ETF’s weighted
average term to maturity or, more appropriately, its duration. Therefore, the ETF’s investment guidelines and
restrictions stipulate how far its weighted average term to maturity or duration can vary from those of its
performance benchmark.
Acknowledging the importance of interest rate risk, government bond-based ETFs are generally offered with
one of four weighted average term-to-maturity targets:
Short-term government bond ETFs: The weighted average term to maturity is equal to that of a short-term
federal government bond index. It is usually restricted to one- to five-year term-to-maturity holdings. An
example is the Bloomberg Barclays Global Aggregate Canadian Government 1-5 Year Float Adjusted Bond
Index.
Mid-term government bond ETFs: The weighted average term to maturity is equal to that of a mid-term
federal government bond index. It is usually restricted to six- to 10-year term-to-maturity holdings.

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Long-term government bond index ETFs: The weighted average term to maturity is equal to that of a long-
term federal government bond index. It is usually restricted to 10- to 30-year term-to-maturity holdings.
Aggregate government bond ETFs: The weighted average term to maturity is equal to that of a federal
government aggregate bond index, with investments covering the entire bond’s term-to-maturity range,
which is one to 30 years. An example is the Bloomberg Barclays Global Aggregate Canadian Government
Float Adjusted Bond Index.

2. Credit risk
Investment in non-government guaranteed fixed income securities entails the assumption of some degree of
credit risk by a fund. This risk often rivals interest rate risk for funds that invest in non-government guaranteed
fixed income securities.
With respect to credit risk exposure, fixed income ETFs are generally offered with one of three broad mandates:
corporate bond ETFs, investment-grade corporate bond ETFs and high-yield bond ETFs. The corporate bond
ETF mandate is the broadest mandate and it has two broad sub-categories: investment-grade corporate bond
ETFs and high-yield bond ETFs. These sub-categories are based primarily on credit ratings.
Corporate bond ETFs: Investments in these ETFs are restricted to fixed income securities issued by domestic
corporations.
Investment-grade corporate bond ETFs: Investments in these ETFs are restricted to corporate bond issues with
an investment-grade credit rating — that is, a minimum credit rating of Baa3 and/or BBB-. An example is the
Bloomberg Barclays Global Aggregate Canadian Credit Float Adjusted Bond Index.
High-yield bond ETFs: Investments in these ETFs are restricted to corporate bond issues with a non-investment-
grade or high-yield credit rating — that is, a credit rating of Ba1 and/or BB+, or lower.
It should be noted that investment guidelines and restrictions pertaining to the amount of credit risk that a
fund can assume is often stated in terms of the minimum credit quality that is acceptable, as well as the fund’s
minimum overall weighted average credit quality.

3. Currency risk
Fixed income ETFs with international or global investment mandates invest in fixed income securities issued
by both foreign governments and corporations. The issues are normally denominated in the bond issuer’s
respective domestic currency, which differs from the currency in which the ETF is priced. If the fund is managed
in a non-hedged manner, it is exposed to potential adverse currency movements. The ETF manager must
decide whether to minimize or eliminate potential currency risk by hedging part or all of the fund’s currency
risk.

INVESTMENT MANAGEMENT TECHNIQUES FOR FIXED INCOME ETFS

The primary objective of an ETF’s investment management is to track, or replicate, the fund’s performance
benchmark as closely as possible over time.
The ETF manager’s success at attaining this performance objective is usually measured in terms of tracking error.
The smaller the tracking error, the more successful l the ETF is at attaining its stated return objective. (An ETF’s
tracking error is discussed in Chapter 7.)
The extent to which the fund attains a smaller tracking error is dependent on the following two factors, both of
which are within an ETF manager’s control:
1. Management fees: An ETF’s management fee is established by the fund’s manager, and due to its nature, will
always cause a fund’s rate of return to be lower than the benchmark’s rate of return by at least that amount
over time. Accordingly, the higher the management fee, the larger the tracking error will be, which makes the
fund less attractive to investors and their investment advisors. The management fee decision is essentially

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a trade-off between the ETF manager’s business goals and the acknowledgment that an ETF with a larger
tracking error generally does not compare well to a competitor’s ETFs with lower tracking errors.

2. Investment management techniques: ETF managers use one of three main passive investment strategies to
minimize the tracking error for a fixed income ETF, as follows:
Replication: With this technique, an ETF’s holdings exactly replicate the securities that comprise its
performance benchmark. Replication has the benefit of having the lowest tracking error of all ETF passive
investment management techniques, but it is only practical and effective for ETFs that have customized
performance benchmarks with a limited number of securities holdings. Accordingly, it is generally only used
for fixed income ETFs that have very narrow investment mandates — typically, industry sector funds.
Statistical sampling (also called representative sampling): This investment management strategy uses
statistical techniques to create a passive fixed income portfolio that minimizes a fund’s tracking error in
comparison to a specific bond market index. It uses the smallest possible number of securities to achieve this
result. This investment management technique is the most popular for fixed income ETFs that attempt to
track the performance of a well-known bond index. Such an index normally contains a very large number of
securities because of the absolute number of bond issues outstanding.
Synthetic replication: This strategy uses a popular ETF investment technique, whereby the ETF enters a total
return swap (TRS) with an approved derivative counterparty, which is generally a large commercial bank or
investment dealer. The ETF holds its investors’ funds in cash and short-term securities, and pays the realized
short-term rate of return daily to the swap counterparty. In return, the TRS counterparty pays a daily rate of
return to the ETF equal to rate of return on the ETF’s performance benchmark, less an agreed upon spread
(fee).

A TRS has become a mainstay in the ETF universe in recent years for two main reasons:
• It is completely customizable, which can be very attractive from a marketing and investor standpoint. A TRS
allows an ETF to offer a rate of return based on a customized performance benchmark. Alternatively, it can offer
the rate of return on a popular fixed income market index without incurring the potential performance-related
drawbacks associated with replication and statistical sampling techniques.
• It allows an ETF’s tracking error to be known in advance. Besides an ETF’s management fee, the only possible
source of tracking error is the counterparty’s swap-related fee, which is typically fixed over the term of the TRS.
From a risk standpoint, it is important to note that a TRS involves the assumption of counterparty credit risk.
Investors must be aware that, should the swap counterparty fail financially at any point, the TRS requires that a
payment be made to the ETF. The ETF will have to attempt to recover the amount of money due in bankruptcy
proceedings with the swap counterparty.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe the roles and responsibilities of a fixed income portfolio manager and trader.
A fixed income portfolio manager is ultimately responsible for the performance of each fixed income
portfolio they manage.
A fixed income trader focuses on executing a portfolio manager’s trades at the best price at the time of the
trade.

2. Describe a repurchase agreement (repo) transaction.

A sale/repurchase agreement involves selling a fixed income security on a specific day at an agreed upon
price and simultaneously agreeing to buy back the same security at a set price on a future date.

3. Compare buy-side and sell-side fixed income professionals.

There are a number of comparisons that can be made between sell-side (fixed income trader at a broker/
dealer) and buy-side (institutional fixed income portfolio manager) fixed income professionals relating to
primary occupational goal/performance factor, secondary occupational goal/performance factor, tertiary
occupational goal/performance factor, source of assets, regulatory capital charges and limitations, use of
leverage, use of short sales, immediate supervisor, direct staff reports, range of securities managed/traded
and individual compensation.

4. Compare passive and active bond management styles, particularly how their approach to interest rate risk
differs.
There are two bond management styles: passive management, where no attempt is made to predict the
direction or magnitude of interest rates, and active management, which tries to profit from interest rate risk.

5. Discuss and describe the properties of duration in portfolio management and, given all of the inputs, calculate
the Macaulay duration and modified duration of a bond and a bond portfolio.
A bond portfolio’s modified duration has five general properties:
« A portfolio’s modified duration is the dollar-weighted sum of individual bond modified durations.
« The proportional change in a bond’s price following a yield change, which is the product of modified
duration and the change in a bond’s yield to maturity.
« For the same maturity, the higher a bond’s coupon rate, the lower its modified duration.
« For the same maturity, the higher a bond’s yield to maturity, the lower its modified duration.
« For the same coupon, the longer a bond’s term to maturity, the greater its modified duration, except
possibly when it is trading at a discount.
n´k
CFt 1
The Macaulay duration formula is as follows: Macaulay Duration = å(t k ) ´ (1 + ( y k ))
t =1
t
´
P

Macaulay Duration
The modified duration formula is as follows: Modified Duration =
(1 + ( y k ))
m
Pk
A portfolio’s modified duration is calculated by the following formula: Dp = å P ´D
k =1
k

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 CHAPTER 8 | MANAGING FIXED INCOME PORTFOLIOS 8 • 55

6. Describe the main strategies associated with a passive bond management style, including buy-and-hold, using
barbell and laddered portfolios and creating a bond index fund.
Buy-and-hold strategy: This strategy means purchasing bonds with available funds and holding each bond to
its maturity, thereby avoiding the interest rate risk on an early sale.
Barbell portfolio: In a barbell portfolio, bonds are initially purchased at both ends of the term structure —
that is, the portfolio consists of 30-year and one-year bonds.
Laddered portfolio: In a laddered portfolio, bonds are initially purchased with each bond’s maturity being up
to 30 years in equal proportions.
Bond index funds: The intent of a bond index fund is to create a portfolio that mirrors a bond index’s
performance and that requires no active security selection. Two methods can be employed to replicate a
bond index:
« Cellular or stratified sampling: A portfolio designed with cells in each of three attributes — maturity,
coupon and credit risk — containing representative bonds in proportions that match the market
proportions of the bonds in each cell.
« Tracking error minimization: This approach uses historical data to model the tracking error variance for
each bond in an index, then minimizes the model’s total tracking error.

7. Describe the process of target date immunization and contingent immunization.

Target date immunization: The need for a portfolio of fixed income instruments with a duration that matches
the timing of the payout.
Contingent immunization: The manager follows an active management strategy until a trigger point occurs,
meaning the point where the portfolio’s value reaches the level at which a zero-coupon bond will mature to
the target amount.

8. Describe the primary active portfolio management strategies, including interest rate anticipation and box
trades.
Interest rate anticipation: A fixed income portfolio manager must decide whether to position their portfolio
with a longer or shorter duration. This positioning mechanism is referred to as a rate anticipation swap,
where funds are moved from one end of the yield curve to the other.
Box trade: The structure of a box trade involves the simultaneous execution of a pair of related fixed income
security swaps. They are related in that the pair of swaps involves the securities of the same two bond
issuers.
« Intermarket domestic box trade: Involves four transactions of four domestically issued fixed income
securities from two Canadian bond issuers.
« Intramarket box trade: Another popular type of box trade that Canadian institutional fixed income
portfolio managers perform involves bonds issued by the Canadian and U.S. governments.

9. Discuss the structure of mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized debt
obligations, foreign currency instruments and real return bonds.
Mortgage-backed securities (MBS): These are portfolios of mortgages assembled and sold in tranches to
increase mortgage capital for lenders. They offer secure higher-yielding medium-term investments that are
comparable to government bonds.
Asset-backed securities (ABS): These are a type of bond with cash flows that are supported by the cash flows
from a specified pool of underlying assets. The underlying assets could be home equity loans, auto loans,
credit card receivables or student loans.

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Collateralized debt obligations (CDOs): These are securities that repackage a collection of underlying
assets and sell multiple classes (tranches) of the asset pool’s interest to investors. A CDO’s cash flows are
supported by MBS, ABS, leveraged bank loans, real estate investment trusts (REITs), corporate bonds or even
other CDOs.
Foreign currency instruments: These are bonds issued by foreign companies and governments or by domestic
companies in foreign currencies.
Real return bonds: These are bonds with payments that are based on inflation levels.

10. Demonstrate the ways derivatives can be used in fixed income portfolio management.
Forward rate agreements (FRAs): Over-the-counter contracts for hedging interest rates that are settled by an
exchange of cash.
Interest rate futures: Exchange-traded contracts used by banks, corporations and individuals to hedge
interest rate risk for future payments.
Interest rate swaps: Agreements made between two parties to exchange interest payments on loans for the
same amount, with each party guaranteeing to pay the other’s interest for a stated period.
Credit derivatives: Financial instruments that derive their value from an underlying credit asset or pool of
credit assets, such as bonds or mortgages, and are designed to transfer and manage credit risk. The most
basic form is the credit default swap (CDS).
Synthetic collateralized debt obligations (CDOs): The credit derivative variant of the cash CDO. In a synthetic
CDO, the originator, which is a bank, retains ownership of the underlying assets and buys protection from
the special purpose vehicle (SPV) using a CDS.

11. Discuss high-yield bonds.

A high yield bond is a bond that currently has a non-investment-grade credit quality rating from one or more
bond credit-rating agencies.
There are several well-designed U.S. high-yield bond indexes in existence.
Bond credit-rating agencies assign a credit rating to a bond.
The most frequently used coupon structures for high-yield bond issuers that need to conserve cash in the
near term are deferred coupon bonds, extendable reset bonds and payment-in-kind (PIK) bonds.

12. Describe fixed income exchange-traded funds (ETFs).

Fixed income exchange-traded funds (ETFs) are normally structured to track or replicate a passive
investment benchmark.
The choice of an ETF’s performance benchmark incorporates three main factors: interest rate risk, credit risk
and currency risk.
Fixed income ETFs use one of three main passive investment strategies to minimize tracking error:
replication, statistical sampling and synthetic replication.

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 The Permitted Uses of
Derivatives by Mutual Funds 9

CONTENT AREAS

The Types of Mutual Funds that Use Derivatives

Mutual Fund Regulations

How Mutual Funds Use Derivatives

The Advantages of Derivatives

The Potential Risks of Derivatives

LEARNING OBJECTIVES

1 | Identify the types of mutual funds that use derivatives.

2 | Describe the regulations that impact how a mutual fund can use derivatives.

3 | Describe the necessary disclosures for a mutual fund to use derivatives.

4 | Distinguish between hedging and non-hedging purposes.

5 | Explain the ways in which mutual funds use derivatives.

6 | Identify the advantages and disadvantages of using derivatives in mutual funds.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

cash-secured put option execution slippage

commodity pools leverage

covered call option National Instrument (NI) 81-102

currency cross-hedge National Instrument (NI) 81-104

delta sale of options

derivatives

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 CHAPTER 9 | THE PERMITTED USES OF DERIVATIVES BY MUTUAL FUNDS 9•3

INTRODUCTION
Due to the leverage and volatility associated with derivatives, mutual funds have been restricted from using them
extensively. However, competitive pressure for higher returns and investor dollars is slowly translating into the use
of more derivatives in mutual funds. Thus, it is important to fully comprehend the particular circumstances under
which mutual fund managers are allowed to use derivatives.
This chapter starts with a review of the mutual funds that typically include the use of derivatives, as well as the
regulations that govern their use. We then provide some examples of how derivatives are used in mutual funds, then
conclude with a description of the potential advantages and disadvantages for investors.

THE TYPES OF MUTUAL FUNDS THAT USE DERIVATIVES

Many mutual funds purchase individual securities, such as equity and fixed income issues, and earn their returns
through returns on the securities within the portfolio. However, many mutual funds also use derivatives.
A derivative is a financial contract whose value is derived from, or depends on, the value of some other asset. The
other asset, which is known as the underlying asset, can be a financial asset, such as a stock or bond, a currency, an
interest rate or an equity index. It can also be a commodity, such as crude oil, gold or wheat. Certain mutual funds,
particularly index funds, are more likely to use derivatives than others.
In Chapter 7, we discussed how index funds try to replicate the return on a market index, such as the S&P/TSX
Composite Index in Canada or the S&P 500 Index in the U.S. Many index funds buy all or a substantial portion of
the constituent securities. Most index funds also use derivatives based on the target index to manage cash balances.
Liquidity and low transaction costs allow derivatives to meet any net redemptions. They also provide quick access to
index returns when a fund receives net contributions.
As noted, other types of mutual funds may also use derivatives. In all cases, the fund’s prospectus must state
whether the fund has the latitude to use derivatives.

MUTUAL FUND REGULATIONS

Canadian mutual fund regulations fall under the jurisdiction of the Securities Acts of each province or territory.
Securities administrators control the activities of mutual funds and their managers and distributors through
National Instruments (NIs), particularly NI 81-102 and NI 81-104.
NI 81-102 applies to mutual funds in Canada and outlines the permitted derivative activities that these funds can
undertake. The following sections of NI 81-102 apply to the use of derivatives in mutual funds:
• 2.7 Transactions in Specified Derivatives for Hedging and Non-hedging Purposes
• 2.8 Transactions in Specified Derivatives for Purposes Other Than Hedging
• 2.9 Transactions in Specified Derivatives for Hedging Purposes

Mutual fund managers are permitted to use derivatives within specific parameters. NI 81-102 permits mutual funds
to use derivatives to reduce risk. In addition, NI 81-102 ensures mutual fund managers do not use derivatives to
speculate to any great degree. Within the allowable uses, mutual fund managers may employ a range of derivatives,
including options, futures, forwards and swaps. NI 81-102 includes specific details that apply to all derivative
positions, such as the following:
• A minimum credit rating for counterparties to over-the-counter (OTC) derivatives contracts. An A rating from
Dominion Bond Rating Service (DBRS) or the equivalent from Fitch Ratings, Moody’s Investors Service or
Standard & Poor’s.

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• A maximum exposure to an individual OTC derivative counterparty of 10% of a fund’s net assets.
• Calculating the exposure to an individual OTC derivative counterparty based on daily mark-to-market exposure.

Furthermore, when a mutual fund values covered option positions, NI 81-102 stipulates that the premium must be
categorized as a deferred credit at an amount equal to the option’s current market value. Any difference resulting
from a revaluation will be treated as an unrealized gain or loss on the investment. Also, the deferred credit will be
deducted from the security’s value when calculating the mutual fund’s net asset value (NAV). The security that is
the subject of a written option is to be valued at its current market value.
NI 81-102 has specific guidelines for valuing forwards, futures and swaps, as per the following:
• The value of a forward contract or swap is the gain or loss on the contract that would be realized if the position
in the forward contract or swap were closed out on the valuation date.
• The value of a standardized future is the gain or loss on the future that would be realized if the position in the
standardized future were to be closed out on the valuation date.
• If daily trading limits imposed by the futures exchange were in effect, the value of the standardized future would
be its current market value.
• The margin paid or deposited on standardized futures or forward contracts will be reflected as an account
receivable. If it is not in the form of cash, it will be recorded as held for margin.

NI 81-104 permits a broader use of derivatives by funds that fall into the definition of commodity pools, which are
funds that buy and sell futures contracts. They are structured and sold as mutual funds. Permitted activities include
a more aggressive use of certain derivatives and the use of borrowed money to extend a fund’s buying power, which
is known as leverage.
NI 81-104 was designed to permit commodity pools to operate without contravening the restrictions of NI 81-102.
In Canada, managed futures funds, which are often thought of as a type of hedge fund, can be structured as
commodity pools. Commodity pools can be sold as mutual funds to general investors, not just accredited investors,
as is the case with most hedge funds. However, regulators require greater disclosure from commodity pools and a
higher proficiency from the mutual fund companies and agents that sell them, when compared to what is required
for conventional mutual funds.

TRANSACTIONS FOR HEDGING PURPOSES

Under NI 81-102, mutual funds may use derivatives for hedging or risk reduction. To qualify as a hedge, the
derivative that is used must:
• Be intended to offset or reduce a specific risk associated with all or part of a position or positions in the fund;
• Have a value with a high degree of negative correlation to the value of the position being hedged; and
• Not be expected to offset more than the changes in the value of the position being hedged.

According to the guidelines in NI 81-102, the easiest way for a mutual fund manager to establish a hedge is to take
a position in a derivatives contract with a payoff that is opposite to, or offset by, that of the position or exposure
to be hedged. By definition, a position that has a payoff opposite to that of the position or exposure to be hedged
will reduce the risk of that position and will have a high negative correlation with it. Using an appropriately sized
derivatives contract will ensure that the derivatives position does not offset more than the changes in the value of
the position being hedged.
Because mutual funds are only allowed to take limited short positions in securities, the majority of securities
positions they will be hedging are long ones. Derivatives positions that have payoffs opposite those of long
positions include the following:
• Short forward, futures and swap contracts

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• Long put option contracts

• Short call option contracts

In addition, NI 81-102 allows currency cross-hedges to qualify as hedge transactions. A currency cross-hedge is a
transaction in which a mutual fund substitutes its exposure to one currency risk for exposure to risk from another
currency, as long as neither is the currency in which the mutual fund’s NAV is determined and the aggregate
amount of currency risk to which the mutual fund is exposed is not increased by the substitution.

TRANSACTIONS FOR NON-HEDGING PURPOSES

Mutual fund managers frequently need to shift funds from one market segment to another, from one type of market
to another and from one country to another. Derivatives allow mutual fund managers to make these switches
quickly, minimizing transaction and market impact costs.
Under NI 81-102, mutual funds may use derivatives for non-hedging purposes within specific guidelines. The most
common use of derivatives for non-hedging purposes is to gain exposure to a market without having to own the
underlying securities.

EXAMPLE
Index derivatives are often used to gain exposure to a market index without having to buy the index’s constituents.

In some cases, derivatives may be used to provide additional portfolio income or the opportunity to buy an
underlying asset at a lower price than it is currently trading at.
Additional regulations in NI 81-102 that relate specifically to the use of derivatives for non hedging purposes include
details such as the appropriate portfolio holdings to ensure that leverage is not being used.

Exhibit 9.1 | Prospectus Disclosure

The use of derivatives must be disclosed and described in a mutual fund’s simplified prospectus. The prospectus
must also explain how derivatives will be used to achieve the mutual fund’s investment and risk objectives, and the
limits of and risks involved with their use.
The following quote from a recent TD Mutual Funds prospectus illustrates the use of derivatives by a mutual fund
for hedging purposes:
When using derivatives for hedging purposes, a Fund seeks to offset or reduce a specific risk associated with all,
or a portion, of an existing investment position, or group of investments or positions. A Fund’s hedging activity
may therefore involve the use of derivatives to manage interest rate risk or to reduce the Fund’s exposure to
underlying interests such as securities, indices and currencies.
This next quote, which is from the same prospectus, illustrates the use of derivatives by a mutual fund for non-
hedging purposes:
A Fund may also use derivatives for non-hedging purposes to gain exposure to underlying interests, such as
individual securities, asset classes, indices, currencies, market sectors and markets without having to invest
directly in such underlying interests; to reduce transaction costs; and to expedite changes to the Fund’s
investment portfolio. While derivatives are being used by a Fund for non-hedging purposes, the Fund must
generally hold cash, the interest underlying the derivative and/or a right or obligation to acquire such underlying
interest in sufficient quantities to permit the Fund to meet its obligations under the derivative contract without
recourse to the other assets of the Fund.*

* TD Mutual Funds Simplified Prospectus; p. 34. Available online at

https://www.tdassetmanagement.com/Fund-Document/pdf/Prospectus/TD-Mutual-Funds/TD_MF_SP_Final_E.pdf.

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HOW MUTUAL FUNDS USE DERIVATIVES

HEDGING USES
Canadian mutual funds use derivatives primarily to reduce exchange rate exposure resulting from holding foreign
currency–denominated securities.

EXAMPLE
Using Derivatives for Hedging Exposure to Exchange Rates
A Canadian equity mutual fund manager holds mostly Canadian equities, with a small allocation to multinational
equities. About 10% of the portfolio is in U.S. equities and 5% is in Japanese equities. This mutual fund is exposed
not only to the price of the equities that make up the U.S. and Japanese positions, but also to the U.S. dollar and
Japanese yen. The fund manager wants to remove the currency risk associated with owning the non-Canadian
equities.
The fund manager sells a U.S. dollar forward contract against the Canadian dollar, which locks in an exchange
rate for the U.S. dollar exposure. The fund manager also sells a Japanese yen forward contract against the
Canadian dollar, which locks in a rate for the Japanese yen exposure. The forward contracts enable the mutual
fund to maintain market exposure to the U.S. and Japanese equities, but they do not carry the currency risk
associated with them.
If the value of the foreign currencies declines over the term of the forward contracts, it will be offset by the gains
on the forward contracts. If the value of the foreign currencies increases over the term of the forward contracts,
it will be offset by the losses on the forward contracts. As the forward contracts approach their maturity, the
manager will likely roll them over — buy them back at a profit or loss and sell new forward contracts — to
maintain the hedges. As long as the hedges are in place, the portfolio’s returns will come only from the changes
in the value of the underlying equities.

NON-HEDGING USES
Mutual fund managers may use derivatives to create or increase exposure to a market or sector, earn additional
income for a fund or provide an additional opportunity for gains. Common uses of derivatives for non-hedging
purposes in fund management fall into the following categories:
• The sale of call or put options to earn additional income;
• The purchase of options, forwards, futures or swaps to gain exposure; and
• The sale of forwards, futures or swaps to reduce exposure.

THE SALE OF OPTIONS

Some mutual fund managers sell options to take advantage of current or desired portfolio holdings and earn
additional income. Although not without risk, the sale of options that are covered (offset) by another exposure or
by cash is considered less risky than the sale of uncovered options.
Canadian mutual fund managers are permitted to sell options, provided they have an offsetting position in the
underlying asset; the right to buy or sell the underlying asset such as purchased call or put options; the cash to cover
the exercise of the sold options; or an adequate combination of all three. These rules are detailed in NI 81-102.

WRITING COVERED CALL OPTIONS

A mutual fund manager can sell a covered call option with a strike price that represents an attractive selling price.
A covered call option is a call that is sold with the underlying asset already owned in the portfolio. The manager

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receives the option premium and, in exchange, agrees to sell the underlying security at the strike price if the
option is exercised. The manager must be comfortable keeping the security if the option is not exercised. The call
option buyer obtains the right to buy the underlying asset at the strike price, and will do so only if the price of the
underlying asset rallies past the strike price. Writing covered call options is a defensive strategy that is designed to
offset losses in long stock positions with income from call option premiums.

EXAMPLE
Selling a Covered Call Option
A Canadian equity fund manager holds shares of Medium Bank. The manager believes the share price will move
very little over the next few months and would like to sell the shares if the price reaches $70. The manager sells a
call option on the shares with a strike price of $70, for which the fund gains a $2 per share option premium. If the
option buyer exercises the call option, the manager has the obligation to sell the shares at $70.
If the share price drops to $50, the buyer will not exercise the call option. The fund retains the Medium Bank
shares and the $2 per share option premium, but owns shares that have declined in value. If the share price rises
to $90, the buyer will exercise the option and the manager will sell the shares at $70. The manager’s effective
selling price for the shares will be $72 ($70 strike price + $2 premium received).

WRITING CASH-SECURED PUT OPTIONS

A mutual fund manager can sell a put option with a strike price that represents an attractive entry price for buying
an underlying security. The put option buyer gets the right to sell the underlying security at the strike price. In
exchange, the manager receives an option premium for agreeing to buy the underlying asset at the strike price if the
put option is exercised. The option premium reduces the manager’s cost of acquiring the underlying security if the
option is exercised. Writing cash-secured put options is a bullish strategy designed to add income if an underlying
asset rallies in value. However, the manager must be comfortable with having no position on an attractive asset if
the option is not exercised.

EXAMPLE
Writing a Put Option
A mutual fund manager would like to buy additional shares of Medium Oil, which are currently trading at $28.
The manager believes the shares will appreciate over the long term, but would like to take advantage of any
short-term dips to add to the fund’s position. To do so, the manager writes a put option with a $25 strike price.
For the sale of the put option, the manager earns $3 per share in option premiums. The fund manager now has
the obligation to buy the shares at $25 should the put option buyer decide to exercise the option.
If the price of Medium Oil’s shares rallies to $35, the put option will not be exercised by the option buyer and the
fund will retain the $3 option premium. If the price of Medium Oil’s shares declines to $15, the put option will be
exercised by the option buyer and the manager will buy the shares at $25. The manager’s effective purchase price
will be $22 ($25 strike price – $3 option premium received).

According to NI 81-102, the mutual fund manager is not allowed to write a put option without having the cash to
buy the shares. Since the fund must have adequate cash to purchase the shares if the put option is exercised, it is
considered to be a cash-secured put option. If the fund does not have the cash to purchase the shares, it could be
at risk should the put option be exercised. Furthermore, since the manager must buy the shares if the put option is
exercised, the stock must be acceptable to the fund.

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APPLICATION OF BOND FUTURES AND FIXED INCOME OTC DERIVATIVES

TO MUTUAL FUNDS
Bond futures and fixed income-related OTC derivatives are used in the management and risk control of fixed income
mutual funds and in the fixed income component of multi-asset class diversified funds, such as balanced funds.
When compared to equity fund derivative applications, one major distinction is that equity-related futures and OTC
derivatives are typically used to either gain or hedge out exposure to entire equity markets generally using equity
index-related derivatives. However, the application of fixed income-related futures and OTC derivatives are more
specifically focused on increasing or decreasing a fund’s exposure to interest rate risk. Equity fund managers tend
to use derivatives to manage a fund’s beta, whereas fixed income portfolio managers generally use derivatives to
manage a fund’s duration.
The two most popular applications of bond futures and fixed income-related OTC derivatives to manage a mutual
fund’s duration are as follows:
• For a fixed income mutual fund, buy (to increase the duration) or short (to decrease the duration) U.S Treasury
Bill (T-bill) futures (90-day term to maturity), U.S. Treasury note futures (10-year term to maturity) and U.S
Treasury bond futures (30-year term to maturity). U.S. Treasury futures are used for modifying a bond portfolio’s
duration since they have high liquidity, very low transaction costs and ease of execution.
A manager would determine the required respective amounts of a combination (linear sum) of the three
futures contracts noted above to attain the bond fund’s targeted duration. It should be noted that there are
only a limited number of Canadian government bond futures contracts. Canadian bond portfolio managers
often use the U.S Treasury bond futures contracts to attain the desired duration result for their domestic bond
funds. They will generally not hedge the U.S. dollar currency exposure that accompanies the U.S. dollar bond
futures position. However, the manager will hedge if it is anticipated that the futures position will be held for
a medium- to longer-term time horizon where currency movements could be detrimental to the bond fund’s
overall rate of return.
• Short selling a longer-term fixed-for-floating interest rate swap reduces the bond fund’s duration more than
if a short-term interest rate swap was shorted. The impact on the bond fund’s duration is very similar to that
realized when shorting a 30-year U.S. Treasury bond future. Conversely, going long a longer-term fixed-for-
floating interest rate swap will lengthen the bond fund’s duration.

INDEX DERIVATIVES
Another common use of derivatives for non-hedging purposes is the creation of index funds. A fund manager can
create an index fund by purchasing all (or most) of the assets in an index in their same (or approximate) weightings.
Alternatively, the manager can use a derivatives contract to get synthetic exposure.
Index derivatives, which are typically forwards and futures, give fund managers exposure to broad market price
movements without having to own each of the securities in an index. Depending on the needs of the fund,
exchange-traded or OTC derivatives can be used. Since OTC derivatives are customized, their attributes can be
tailored to a mutual fund’s specific requirements.
Swaps are also sometimes used to replicate an index’s returns. An index fund might use a swap as an alternative to
an exchange-traded derivative, if no listed derivatives are available. Alternatively, it might be attractive to a fund
manager to use a swap that is customized for a fund’s specific requirements.

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EXAMPLE
A Total Return Index Swap
The manager of a fixed income index mutual fund holds most of the securities that make up the index. For new
inflows into the fund, the manager decides to buy T-bills instead of the index’s fixed income securities and use a
swap to gain exposure to the return on the index. The manager enters into a swap based on $10 million that calls
for a quarterly exchange of return based on the T-bills and the index.
Although the manager continues to own the T-bills, their return will be paid to the swap counterparty, while the
return on the fixed income index will be paid by the swap counterparty to the fund. The result is that the fund’s
returns will be that of the fixed income index, net of any costs that are incurred in undertaking the swap. Figure
9.1 is a graphical depiction of the cash flows in this scenario.

Figure 9.1 | Swaps and the Return on an Index Fund

Return on T-Bills
Index Fund Swap Counterparty
Return on Index

Return on T-Bills

Treasury Bills

If during the first quarter, the return on the T-bills was 0.75% and the return on the index was 2%, the terms
of the swap require the mutual fund to pay the swap counterparty $75,000 ($10 million × 0.0075) and the
swap counterparty to pay the mutual fund $200,000 ($10 million × 0.02). Like most swaps, there is likely
a clause that requires only a net payment by the party that owes the larger of the two payments — that is,
the principal is not exchanged in an interest rate swap. In this case, the swap counterparty pays the mutual
fund $125,000. This quarterly calculation and exchange of payments would continue until the end of the
swap’s term.

THE ADVANTAGES OF DERIVATIVES

The use of derivatives by mutual fund managers benefits investors by offering opportunities to obtain exposure
to certain assets and by mitigating certain kinds of risk. The advantages that derivatives provide to mutual fund
managers include the following:
• Risk reduction
• Ease of execution
• Lower costs
• Greater asset selection
• More portfolio income

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RISK REDUCTION
One of the most important uses of derivatives for mutual fund managers is the ability to reduce risk. For example,
derivatives are often used to reduce the currency exposure otherwise associated with foreign currency–denominated
investments, enabling investors to own foreign securities without worrying about exchange rate fluctuations. Call
options are also sold on existing stock positions to reduce losses during flat or down markets.

EASE OF EXECUTION
Derivatives contracts permit a fund manager to purchase a large number of diverse securities in a single transaction,
which could be difficult, time-consuming and costly if each security in the index was purchased individually.
In addition, derivatives can help avoid execution slippage, which occurs when the execution of a transaction causes
subsequent prices to worsen. A manager benefits from the ease and low cost with which a derivatives transaction
can be executed.
Stock index forwards can also be used in asset allocation strategies. Suppose the manager of a balanced mutual
fund receives new cash of $10 million. The manager’s allocation to the equities index is currently 30%. Rather than
purchase individual stocks to mirror the index in small and odd amounts, and pay the slippage, the manager buys
stock index forward contracts with a notional value of $3 million (30% of $10 million). This provides a proxy for
owning the equities in the index, and the manager can implement the asset allocation quickly and cheaply.

LOWER COSTS
One of the major benefits of using derivatives as a proxy for owning individual securities is lower transaction and
administration costs. This is particularly true for international funds, which face potentially higher costs for analysis,
custodians and slippage. As a result, some international funds, particularly index funds, use derivatives contracts
to gain exposure to foreign markets, rather than buying foreign securities directly. If the fund manager can obtain
exposure to the market at a lower cost than owning the securities outright, cost savings can be passed along to
investors in the form of lower fees and management expenses.

GREATER ASSET SELECTION

Mutual fund managers may be able to use derivatives to gain access to markets that would otherwise be difficult
or impossible to enter. For instance, a manager could easily gain exposure to the emerging markets asset class by
buying futures based on the MSCI Emerging Markets Index, which represents 1,136 securities in 24 countries. The
availability of specialty and foreign derivatives increases the variety of assets available to investors.

MORE PORTFOLIO INCOME

Derivatives can be used to increase returns in mutual fund portfolios when markets are stagnant or falling. The sale
of covered call options can increase portfolio income from underlying securities. However, if the underlying securities
are sold and subsequently rally, there is a risk that the manager will have missed potentially greater returns.

THE POTENTIAL RISKS OF DERIVATIVES

Not all mutual fund managers use derivatives. There are disadvantages and risks associated with their use in mutual
fund management, including the following:
• Income considerations
• Management of expiration dates
• Portfolio attributes
• Limited gains

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• Transparency
• Tax considerations
• Costs
• Credit and counterparty risk

INCOME CONSIDERATIONS
In the use of derivatives in mutual funds, portfolio income is both a potential advantage and disadvantage. Although
options can be written to earn income, the fund manager using forwards and futures as a proxy for securities does
not collect dividend or interest income that would otherwise be earned by security holders. The pricing of a futures
or forward contract already takes into account the effect of dividends or interest income payable on the underlying
asset, but there are no explicit payments related to dividends or interest to the owner of the derivatives contract.

THE MANAGEMENT OF EXPIRATION DATES

Derivatives contracts have an expiration date, at which point the contracts must be rolled over or renewed to
maintain the exposure. The associated costs and administration of expiry may be an issue.

PORTFOLIO ATTRIBUTES
Using derivatives for hedging purposes may not provide adequate protection against market risk if there is a weak
correlation between the portfolio’s securities and the derivatives contracts used for hedging.

EXAMPLE
Government bond futures contracts provide an inadequate hedge for corporate bond holdings, because the
futures do not provide protection against the credit spread risk of corporate bond holdings.

When an option is used, the price sensitivity of the option (delta) will help determine the effectiveness of the
hedge or position taken. An option with little value and a strike price that is substantially above or below the asset’s
current price will not change much in value, even for relatively significant changes in the underlying asset’s market
value.

LIMITED GAINS
Derivatives are often used to hedge the risk associated with foreign currency investments or interest rates. While
the purpose of hedging is to reduce risk, if the fund manager forecasts incorrectly, hedging may result in a loss or a
smaller gain for the fund than would otherwise be the case.

EXAMPLE
A fund manager hedges against the decline in a currency’s value using a forward contract, and the hedged
currency subsequently rises in value. As a result, the fund’s returns may suffer in comparison with peer funds or
indexes.

The sale of call options may also limit gains, because it obliges the fund manager to sell the underlying security at
the strike price. If a written call option is exercised, the fund may lose opportunities for future gains that it would
otherwise accrue from owning an appreciating security.
Similarly, a fund manager can write a put option to acquire an attractive security for the portfolio. The sale of a put
option obliges the manager to buy the underlying security at the strike price, but provides the fund with income
from the option premium. The written put option will only be exercised by its owner if the security’s price declines
below the put option’s strike price. If the put option is exercised, the manager must buy the security at the strike
price. And if the price of the security continues to decline, the fund will suffer losses.

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TRANSPARENCY
Canadian mutual fund regulations require that the use of derivatives be disclosed in a fund’s prospectus — see
Exhibit 9.1 entitled Prospectus Disclosure. Details of derivatives contracts are disclosed in the financial statements
that accompany the fund’s prospectus. In some cases, the time lag associated with the publication of the financial
statements and the complexity of the contracts involved may make it difficult for an average investor to understand
the true exposure offered by a mutual fund.

TAX CONSIDERATIONS
One commonly enjoyed benefit of investing is that capital gains and dividends receive preferential tax treatment.
However, the income that typically accrues to fund holders as a result of futures and forward contracts is taxed as
income and therefore does not normally receive any preferential treatment.
Tax considerations are very important outside tax-sheltered plans, because the return to the investor is an after-tax
return. Within registered savings plans, such as RRSPs, there is no preferential benefit to earning returns as capital
gains over ordinary income. Therefore, depending on the investor’s perspective, there may or may not be a tax
consideration for mutual funds that use derivatives.

COSTS
Not all mutual funds that use derivatives have lower costs than those that do not use them. Extra administrative
and management costs are associated with the use of derivatives.

CREDIT AND COUNTERPARTY RISK

A mutual fund using derivatives contracts is exposed to the counterparty’s creditworthiness. In the case of an
exchange-traded contract, this means exposure to the derivatives clearinghouse, which is the entity that provides
clearing and settlement services for the derivatives contracts. This risk is minimal. However, the use of one or two
financial institutions as counterparties for a fund’s OTC derivatives contracts, whether used for hedging or non-
hedging purposes, concentrates a mutual fund’s counterparty exposure.

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SUMMARY
After completing this chapter, you should be able to:
1. Identify the types of mutual funds that use derivatives.
Certain mutual funds are more likely to use derivatives than others, particularly index funds.

2. Describe the regulations that impact how a mutual fund can use derivatives.
NI 81-102 applies to mutual funds in Canada and outlines the permitted derivative activities that these funds
can undertake.
NI 81-104 permits a broader use of derivatives by funds that fall into the definition of commodity pools,
which are funds that buy and sell futures contracts.

3. Describe the necessary disclosures for a mutual fund to use derivatives.

The use of derivatives must be disclosed and described in a mutual fund’s simplified prospectus. The
prospectus must also explain how derivatives will be used to achieve the mutual fund’s investment and risk
objectives, and the limits of and risks involved with their use.

4. Distinguish between hedging and non-hedging purposes.

NI 81-102 specifies the conditions under which a mutual fund can use derivatives in hedging and non-
hedging positions.
To qualify as a hedge, the derivative that is used must:
« Be intended to offset or reduce a specific risk associated with all or part of a position or positions in the
fund;
« Have a value with a high degree of negative correlation to the value of the position being hedged; and
« Not be expected to offset more than the changes in the value of the position being hedged.
The most common use of derivatives for non-hedging purposes is to gain exposure to a market without
having to own the underlying securities.

5. Explain the ways in which mutual funds use derivatives.

Hedging: Canadian mutual funds use derivatives primarily to reduce exchange rate exposure resulting from
holding foreign currency–denominated securities.
Non-hedging: Common uses of derivatives for non-hedging purposes in fund management fall into the
following categories:
« The sale of call or put options to earn additional income;
« The purchase of options, forwards, futures or swaps to gain exposure; and
« The sale of forwards, futures or swaps to reduce exposure.

6. Identify the advantages and disadvantages of using derivatives in mutual funds.

The advantages of using derivatives by mutual fund managers include risk reduction, ease of execution,
lower costs, greater asset selection and more portfolio income.
The disadvantages of using derivatives by mutual fund managers include income considerations, the
management of expiration dates, portfolio attributes, limited gains, transparency, tax considerations, costs,
and credit and counterparty risk.

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 Creating New Portfolio
Management Mandates 10

CONTENT AREAS

New Investment Product Development Process

Investment Guidelines and Restrictions

LEARNING OBJECTIVES

1 | Describe the key steps for analyzing the potential for investment products and developing new ones.

2 | Discuss the importance of a thorough assessment for a new investment product’s potential market
size and the challenges of developing that assessment.

3 | Describe the various legal and regulatory issues when considering the development of a new
investment product.

4 | Identify the key information requirements for preparing a financial forecast for a new investment
product.

5 | Explain the steps to follow after project approval has been granted for a new investment product.

6 | Describe the purpose of an investment product’s investment guidelines and restrictions, and the
critical importance of a well-defined investment policy.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

backtesting performance benchmark

deferred sales charges (DSC) pre-operational audit

go/no-go decision pro forma financial projection

investment-grade credit quality rating project management committee

management expense ratio (MER) road shows

micro-capitalization stocks seed capital

new product development committee

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INTRODUCTION
The primary purpose of this chapter is to explain how an investment management firm assesses and develops
new investment funds and products. The chapter starts with a description of the typical development process of a
new product and the key steps involved. We also explain each major step in the assessment process, as well as the
information and assumptions that must be in place to bring the project to a go or no-go decision. The chapter goes
on to describe the key project management steps that must be followed after a project’s approval in order to bring
the new investment fund or product to the marketplace.
Finally, we discuss why it is important to have well-developed investment guidelines and restrictions for each new
fund or product, and describe the key factors to consider when developing investment guidelines and restrictions for
equity, fixed income and balanced fund mandates.

NEW INVESTMENT PRODUCT DEVELOPMENT PROCESS

The investment management industry is well-known for its ingenuity and ability to develop products that connect
both new and existing investors with perceived opportunities in capital markets. The industry, particularly its
individual investor component, is anything but staid. However, like with all new business opportunities, there is
risk involved in creating new products and services. As such, it is prudent to have a well-designed new product
development system and process in place to lower risk and lead to better decisions regarding new products.
There are nine key steps in assessing and developing new investment products, as follows:
1. Identifying potential market opportunities
2. Determining the required portfolio management skills, and if external investment management skills will be
needed
3. Assessing the market
4. Determining the legal and regulatory restrictions
5. Developing a marketing and distribution strategy
6. Preparing a financial forecast, including pro forma financial statements
7. Obtaining approval from the investment management firm’s new product development committee
8. Developing project management timelines
9. Launching the product

Each of these steps will be covered in detail in the following sections (see Figure 10.1).

Figure 10.1 | The New Product Development Process

1. Identifying Potential • Originating new product ideas.

Market Opportunities • Emanating from inside the investment firm or outside of it from investors or
competitors.

2. Determining the Required • Assessing if the investment firm has the portfolio management skills required
Portfolio Management for the new product. If not, a decision will need to be made to consider an
Skills outside sub-advisor.
• The backtesting process is required if an internal track record does not exist.

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Figure 10.1 | The New Product Development Process

3. Assessing the Market • Analyzing potential investor interest in the new product.
• Using competitors’ products if entering an existing product market, which is
more difficult to assess if the new product is a completely novel concept.

4. Determining the • Confirming and integrating all applicable legal and regulatory guidelines and
Legal and Regulatory restrictions into the new product’s design.
Restrictions

5. Developing a Marketing • Developing a marketing and distribution strategy that is most suitable and
and Distribution Strategy appropriate for the new product.

6. Preparing a Financial • Preparing a detailed financial forecast for the new product, including details
Forecast regarding investment management fees and the sales and marketing budget.
• Forecasting usually involves numerous sales growth scenarios with associated
probability weights.

7. Obtaining Approval • Presenting the new product proposal to the firm’s committee or panel
from the Investment responsible for approvals.
Management Firm’s New
Product Development
Committee

8. Developing Project • If the product is approved, developing and managing a detailed project
Management Timelines management timeline and budget, with interim reviews to ensure the project
remains within its parameters.

9. Launching the Product • Pre-launch activities, including distributing sales and marketing materials,
developing advertising programs and holding road shows for distributors.

STEP ONE: IDENTIFYING POTENTIAL MARKET OPPORTUNITIES

New investment products or fund concepts generally arise when they are either pulled to market or pushed to
market.
A product market “pull” occurs when a new investment product idea originates from within the investment fund
or product market. Typically, current investors or product distributors are the sources of new fund ideas. In other
words, the investment management firm is being “pulled” towards a potential new investment fund or product
opportunity.
When a new investment fund or product concept originates from a firm’s portfolio management area, it is commonly
referred to as a capital markets “push”. This is the case because the new investment fund concept originates in the
capital markets and is “pushed” through the firm to potentially become a new investment product on the markets.
The portfolio management staff promotes a new investment fund or product concept for one or both of the
following reasons:
• Identifying an internal portfolio management skill that appears to be competitive, performance-wise, in relation
to what is already in the marketplace — if, indeed, there is any competition in this area.
• Identifying an emerging or underdeveloped capital market sector or sub-sector that could form the basis for a
new specialized investment mandate.

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NEW PRODUCT DEVELOPMENT COMMITTEE

The primary role of a new product development committee is to vet and assess new investment fund or product
opportunities for an investment management firm. The committee fulfills this role by doing the following:
• Establishing a properly constituted multidisciplinary committee with the requisite expertise in all of the areas
involved in the creation, launch and management of new investment funds and mandates.
• Creating a project management process that is:
Tailored to the development of new investment funds mandates
Thorough and comprehensive
Has a well-designed decision-making process
Supplies data needs
Includes an analysis process
Uses estimating methodology

The new product development committee is not permanent. It is activated whenever the firm is considering a
new product for development. The committee will meet on a periodic basis as a new product proceeds through
the analysis and final review stages. However, most mutual fund firms have a vice-president responsible for
new product development, who is typically responsible for the screening and analysis activities related to the
development of a new product.
A properly structured new product development committee can bring a number of potential benefits to a firm’s new
investment product development process, as follows:
• Its structured new product decision-making process should lead to better go/no-go decisions than an ad hoc
process would.
• It can lead to a more efficient and effective new product development process, one in which less effort and
fewer resources are spent analyzing potential new mandates.
• It can get new investment funds or products to market quicker, and therefore improve the odds of financial
success.
• It creates a repeatable process or model that can be refined over time.

STEP TWO: DETERMINING THE REQUIRED PORTFOLIO

MANAGEMENT SKILLS
Fundamental to their nature, all investment products and services are built on portfolio management skills. Once
a market opportunity has been identified, a firm needs to determine if it has the necessary in-house portfolio
management skills or if it needs to hire external investment managers. Any potential opportunity can only be
accessed through the services of a portfolio manager who hopefully has the skills and abilities to earn competitive
rates of return in a particular part of the capital markets.
In general, investment management firms that focus on the institutional or high-net-worth markets — or both —
offer investment funds that solely use internal portfolio managers. However, in the individual investor marketplace,
particularly the mutual fund sector, the use of external third-party portfolio managers is quite common.
For a mutual fund manager, the use of third-party portfolio managers is not necessarily viewed as a weakness.
Mutual fund distributors and investors appreciate that not all mutual fund managers have superb portfolio
management skills and abilities in all aspects of the world’s capital markets.

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Nowadays, the need to outsource portfolio management skills is seen as prudent, especially for investment
products that have global investment mandates. It is generally more cost and time effective to hire third-party
managers than try to acquire all of the necessary skills in-house. However, remember from Chapter 4 that from
a regulatory and business perspective, a fund manager is responsible for all of the activities of the sub-advisors it
employs. Therefore, the fund manager must conduct detailed due diligence of potential third-party managers.

DIVE DEEPER

Backtesting
To determine whether an investment management firm’s team has the requisite skills to manage a new
product, it will perform a backtest. As the name implies, backtesting involves the retrospective analysis
of a potential investment product. Of course, backtesting is not required if the firm already has a fund
with a sufficiently long performance record that meets the new fund’s investment objectives, as well an
investment strategy that is consistent with it. If such an internally managed fund does not exist — and
if hiring another investment manager with an appropriate track record on a sub-advisory basis is not
feasible — then backtesting will form an integral part of the analysis.
Backtesting is typically fraught with a number of inherent biases and weaknesses, and must be used
and analyzed carefully to ensure the results are useful. Essentially, the new product development
team is asking the investment team the following: “If you had been given this fund mandate three
years ago, how would you have managed it and what would your results have been?” Given the fact
that the team knows exactly how the market performed over the last three years, the answer to this
question is inevitably biased. This is one reason why regulators are becoming more concerned about
the inclusion of backtesting results in sales and marketing literature, advertising and presentations by
investment managers. The regulators’ concerns centre on the potential misrepresentation that occurs if
the backtesting results are not clearly noted and described as such within these materials. Backtesting
results are often appended to actual performance data, but are not clearly identified. It is quite likely
that new regulations will be approved regarding the use and presentation of backtested results in sales
and marketing materials.*

* For more information on the Ontario Securities Commission’s comments about back-testing, go to
http://www.osc.gov.on.ca/documents/en/Securities-Category3/csa_20110705_31-325_marketing-practices.pdf.

BENCHMARK SELECTION
It is critical that the appropriate performance benchmark is selected for a new fund. The performance benchmark
is used to explain a fund’s performance, and it can be embarrassing or rather difficult to explain a change in a fund’s
benchmark after it has been launched. Investment management performance is measured in three basic ways, as
discussed below.
First, the use of peer or competitive performance results, which was discussed in detail in Chapter 5, is very common
in the institutional investment management marketplace. An investment manager’s quantifiable performance
ranking is a key determinant for both winning and losing new investment mandates from institutional investors.
These results are also the major factor that institutional investors use when terminating existing investment
management contracts.
The second most popular performance benchmarks are market indexes, such as the Dow Jones Industrial Average
(DJIA), the S&P 500 Index, and the S&P/TSX 60 Index. While these market-based indexes are also used by
institutional investors, they tend to be treated as secondary or supplemental to an investment manager’s peer
survey ranking. Institutions tend to use market-based indexes for asset mix analysis and changes.
However, in the individual investor marketplace, the roles of the two types of performance benchmarks are
reversed. Mutual funds tend to use market-based indexes when presenting the results and performance of their

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investment funds. Peer performance comparisons, such as quartile rankings, are used much less often in sales and
marketing materials and in reports to individual retail investors.
The third performance benchmark is a fund’s absolute return, which is the primary performance benchmark
for exempt market products, such as hedge funds, private equities and other partnerships. With these types of
investment funds, a manager’s fee income is primarily in the form of a performance-based fee that is based on a
fund’s absolute rate of return, with no reference whatsoever to peer performance ranking or market-based indexes.

STEP THREE: ASSESSING THE MARKET

Assessing the market for a new investment fund or product is a matter of conducting a proper assessment of the
demand for the new product. It is a very difficult and challenging activity to gauge or assess investor demand, since
it is dependent on a number of factors. Some of the more important factors are as follows:
• The general tone of the capital markets, particularly equities.
• The overall performance of the particular capital market sector if the new mandate is especially focused.
• The firm’s investment performance in both its absolute return and its performance relative to the capital market
sector the new fund is focused on.
• The adequacy of a firm’s distribution efforts

The market assessment must incorporate the various investor needs, including income, growth or capital gains.
Does the new product offer one of these needs or a combination of all three? Assessing investor needs is very
important and can result in an incredibly large market opportunity if they are assessed properly and the product’s
design accommodates them.

EXAMPLE
New Investment Products that Meet Investor Needs
Some examples of new investment products that meet a number of investor needs are as follows:
• Products that offer exposure to an industry theme, such as alternative energy.
• Exchange-traded funds (ETFs), which have grown substantially during the past 10 years, because they provide
investors with a myriad of funds that meet numerous investment mandates. These mandates range from
funds that attempt to replicate the return of popular market indexes, such as the S&P 500 Index, to funds
that specialize in very narrow parts of the equity market, such as biotechnology stocks. ETF investment
mandates are often not original, but their unique difference is that they offer investors exposure to equity
markets by purchasing stock exchange–listed securities, rather than by purchasing a mutual fund with
a similar mandate. Unlike mutual funds, ETFs can be traded very easily throughout the day. In addition,
the fees and commissions associated with ETFs tend to be much lower than those associated with most
mutual funds.

Another major factor in the market assessment of a new investment product is whether it is entirely new or an
imitation of an existing product. Of course, assessing the market for a novel product is difficult, because there are
no other products in the marketplace that can be used as a benchmark or proxy for market assessment. When the
new product that is being analyzed is entering an existing market sector, the investment firm must be confident that
the product will offer comparable or better results than its existing competitors’ funds. The firm needs to assess the
distribution possibilities, since large distributors have more clout and might be able to push the copycat product
further along in the market.

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POTENTIAL BENEFITS OF BEING FIRST TO MARKET

Unfortunately, financial innovations are not patentable. As such, the firms that are first to market with an innovative
fund or investment product do not generally enjoy the financial advantages associated with market exclusivity,
which companies with new products in other industries enjoy through protection from design or intellectual
property laws.
However, investment firms recognize this fact and therefore attempt to bring new funds to the market as quickly as
possible and with the greatest distribution they can provide. Industry participants fully expect that the successful
launch of a new fund will bring competitors into the market. Usually, the more successful the new product launch is,
the quicker and more profound the competitive response will be.
Some of the potential benefits of being first to market include the following:

An Increase in Assets Unless the new product launch is a total failure, the firm has accumulated additional
Under Management assets to manage and therefore earns additional investment management fees.

Market Share A successful launch, combined with good investment results and effective sales and
Leadership marketing efforts, frequently results in the opportunity to obtain and maintain a
respectable market share. Often, particularly with mutual funds, the firm that enters the
market first with a new fund can also benefit from additional investor awareness of the
fund. The firm can entrench itself in the lead as competitors spend more resources to
make investors aware of their “follow-on” investment products.

Innovator Status The firm that is first to market will often be recognized as an innovator in the market
and will attract the attention of the financial press and of financial product distributors.
This recognition makes it potentially easier for the firm to find and negotiate better and
broader distribution relationships for future product launches.

CAPITAL MARKET ACCESSIBILITY AND LIQUIDITY

Although it may often seem unimportant, at the product development stage, it is prudent to assess whether the
new fund can actually access the various securities for the fund. This is particularly relevant when the new fund’s
mandate includes investments in foreign securities. There are actually two levels of accessibility that must be
examined.
First, the firm needs to determine whether the securities laws in the foreign country of interest permit foreign
investors to hold securities issued in their markets. This is a critical question, since all Canadian mutual funds and
many other types of investment products are based on legal structures, such as trusts, corporations and limited
partnerships, which are Canadian legal entities and, accordingly, are considered to be foreign investors. The legal
and securities regulations must be reviewed early in the fund’s mandate development process to confirm that it can
invest in securities that are issued and traded in these foreign capital markets.
Second, the fund manager must also be sure that the investment dealers it does business with can also trade on
these particular foreign exchanges or markets. Of course, the larger the investment dealer, the more likely it has a
current membership on the stock exchanges of the countries the new fund is set to invest in.
Beyond market accessibility, market liquidity must also be determined. Some potential or perceived investment
opportunities might be difficult to capture in reality if the market and particular securities the fund is set to invest
in are very illiquid. For the majority of new investment funds, liquidity is not generally an issue. However, it can be a
negative factor when a firm considers investing in foreign countries whose capital markets are in their infancy.
Market liquidity can also be an issue in portions of North American capital markets, such as micro-capitalization
stocks, which are companies that tend to have a market capitalization between $50 million and $300 million,

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although some analysts and fund managers give a broader range of $10 million to $500 million. Liquidity is usually
not a “fund concept killer”, but it should be evaluated early in the development process.

STEP FOUR: DETERMINING THE LEGAL AND REGULATORY RESTRICTIONS

As discussed in Chapter 3, securities regulations apply to both investment management firms and investment
products that are managed or distributed in Canada, and they can vary for different types of products.
These restrictions must be considered when developing a new investment product. Table 10.1 compares the legal
and regulatory restrictions that apply to different groups of Canadian investment products and funds.

Table 10.1 | Canadian Investment Products and Regulatory Agencies

Product Offering Document Investor Type Regulator

Mutual fund Prospectus All OSC
Pooled fund, limited partnership (hedge funds) Offering memorandum Exempt/accredited OSC
OSC: Ontario Securities Commission

MUTUAL FUNDS
From a regulatory perspective, mutual funds are the most regulated of all Canadian investment products. They
are usually structured legally as unit trusts, although a few are structured as corporations. The appropriate legal
structure must be created and registered with the various provincial or federal authorities.
After it is completed by the mutual fund manager’s legal counsel, the fund’s prospectus must be filed for approval
with each of the provincial securities regulators where it will be distributed. The time to obtain approval for the
prospectus from the various provincial securities regulators is usually in the range of four to eight weeks after the
filing date. This timing is dependent on the following three major factors:

The Time of Year Many mutual fund companies bring new funds to market late in the calendar year to
help attract investors who are making RRSP contributions during January and February.
Accordingly, securities regulators are often inundated with prospectus filings during the
late third quarter or early fourth quarter of the year. This flood of filings often extends
the product review time for newly submitted mutual fund prospectuses.

A “Clean” Prospectus It goes without saying that it is critical that a firm have competent legal and accounting
counsel when it is creating a prospectus for approval. Prospectuses receive critical review
by the securities commission staff responsible for the registration of new mutual funds.
A poorly crafted prospectus will result in a greater number of deficiencies identified by
the regulators. These deficiencies are noted in a deficiency letter and sent to the mutual
fund manager. Each and every deficiency in the filed prospectus must be corrected and
resolved to the satisfaction of the securities regulator before the prospectus approval will
be granted. The greater or the more severe the deficiencies are, the longer it will take for
the firm to finally obtain complete securities regulator approval.

Exemptions Often, for competitive advantage, prospectuses that are filed for regulatory approval will
contain requests for a particular exemption or exemptions from regulations. Depending
on the number and magnitude of each requested exemption, the length of time to
obtain regulatory approval will be extended.

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INVESTMENT PRODUCTS FOR EXEMPT OR ACCREDITED INVESTOR MARKETS

A number of investment products and funds are designed explicitly for investors who meet the definition of exempt
or accredited investors (see Chapter 4). These include investment products such as hedge funds, private equity
funds, leveraged buyout funds, infrastructure funds and so forth. These investment products are usually legally
structured as limited partnerships.
In Canada, investment products that are only designed for and distributed to exempt or accredited investors do
not require an approved prospectus. These products are generally distributed with an offering memorandum or a
partnership agreement, or both. These offering and subscription documents must be filed with securities regulators
prior to the product’s sale and distribution. However, these documents do not require the approval of securities
regulators. Therefore, there is no timeline for regulatory approval.

STEP FIVE: DEVELOPING A MARKETING AND DISTRIBUTION STRATEGY

An excellent marketing and distribution strategy is required for the successful launch of a new investment fund,
particularly since there might be a very short performance track record — or almost none at all — for use in sales
and marketing materials.

THE MARKETING “STORY”

The launch of a new investment fund requires a new or unique “story” to create investor interest. Product features
per se will usually not be sufficient to create interest. Generally, the marketing theme for a new fund is built around
the investment manager’s skills and abilities. For example, does the new fund’s manager have a unique investment
management process or skill? Invariably, the answer is yes, but the marketing challenge is to explain the new fund’s
investment attributes, then further explain how its particular investment strategy will capitalize on this market
opportunity.
The marketing challenge is also typically impacted by whether the new fund under development is innovative and
first to market, or if it is entering an area of the market that has been opened up by other investment firms. Each
situation has its own unique marketing challenges.
When a new investment product is entering a market where competitive products currently exist, the marketing
story has to depend heavily on the portfolio manager’s abilities. The benefit of entering an existing market is that
the competition has already spent resources to educate the public about the benefits of investing in a particular
type of fund or part of the capital markets. The challenge in this case is to develop a marketing story that is
sufficiently unique to set apart the new fund or product from existing funds.
Not surprisingly, the marketing challenges for an innovative investment fund or product are the opposite of those
involved in entering an existing sector of the marketplace. A new product’s marketing story does not have to deal
with comparisons to competitors’ products. However, it does have to focus on explaining the benefits of investing in
a new type of fund and on why the portfolio manager is appropriate.

DISTRIBUTION CHANNELS
The other major marketing challenge is to decide which distribution channels and distributors to use. (A distribution
channel is how a fund gets to investors so they can buy it.) In many instances, the choice of distribution channels
and distributors is very straightforward. In the example of a new mutual fund product, these decisions have already
been made as a matter of overall corporate strategy. As a result, the new investment fund or product will be
marketed under the mutual fund’s corporate brand by the same distributors that currently have agreements in
place. However, new distributors might be considered if they have some unique distribution capabilities that are
very well-suited to the new investment fund or product.

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STEP SIX: PREPARING A FINANCIAL FORECAST

One key step in the product development process is to bring together all of the assumptions into a financial forecast
or model for the new product under consideration. Generally, this includes communicating all of the new product’s
financial or monetary aspects. The forecast integrates the product development team’s assumptions about the
following key variables:
• Sales volumes
• Distributor compensation, including upfront commissions and trailer fees
• Seed capital requirements
• Third-party expenses
• Investment management fees

Usually, the ideas for a new investment fund start with a back-of-the-envelope version of the fund’s financial model,
which becomes more refined as the product development process continues.

SALES VOLUMES
The key variable in the financial analysis of a new investment fund is the sales estimate. The amount of sales leads
directly to the amount of assets under management (AUM), which, in turn, leads to the gross revenue — or investment
management fee — assumption for the fund manager. This is the case because investment management fees are
usually a fixed percentage of a fund’s AUM.
Unfortunately, a new fund’s sales estimate is also the most difficult variable to forecast. Actually, the projected AUM or
fund sales estimate contributes more risk to the new fund’s financial forecast than all of the other variables combined.
The only exception would be an investment fund, such as a hedge fund, where performance fees are directly related to
both the fund’s AUM and its absolute rate of return.
The sales estimate for a new fund requires the greatest amount of effort to forecast. It is a difficult task for new funds
that are entering an established sector, but it is a particularly daunting task for the development of innovative fund
launches. Of course, in the latter case, there is no competitor comparison that can be used as a basis or benchmark to
assist the new product development team in preparing a sales estimate for the new fund.
To create a sales forecast for an innovative product, a firm would first look at related funds to see what amount of sales
success each has had. The sales estimate resulting from such a comparison introduces lots of risk, since the new fund,
which is innovative, has no direct comparison in the market. Nevertheless, though the related funds are certainly not
valid as head-to-head comparisons, their performance can be used as reference points during the development of the
new fund’s sales plan and volume targets.
The next step is to carefully consider which distributors the competition used when they launched their related funds.
This step is particularly important if an investment firm is considering using a different syndicate of fund distributors.
Some distributors have strengths in selling particular types of new investment products, which needs to be taken into
account when deciding which distributors an investment firm wants to hire.
A firm will often discuss its new product with key distributors on a pro forma basis when determining the sales
estimate. These discussions focus on gauging or estimating the amount of sales each distributor might be able to
deliver. Also, information will often arise from these discussions that indicates how sales estimates would change if the
product’s mandate or design were to change somewhat.
Finally, and often most important, is the tone of the overall equity market. Market tone at the time of a new fund
launch can tremendously affect the initial sales results. It is not uncommon for fund managers to pull a new fund if the
financial markets turn “sour” just before the planned product launch.

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DISTRIBUTOR COMPENSATION
Distributor compensation generally takes two forms: upfront commissions and trailer fees. Commission fee scales,
which tend to be quite similar for the majority of distribution firms, are negotiated between the fund manager and
its respective distribution firms. In the case of mutual funds, the prospectus must include the maximum commission
that can be charged by any of the fund’s distributors.
Most mutual funds offer a selection of options with regard to sales commissions. Investors can pay a one-time
upfront commission they negotiate with the distributor’s agent, which is the investment advisor or mutual fund
salesperson. As an alternative, investors can select from one or two options that permit them to pay the sales
commission on a deferred basis over time. These alternative sales commission arrangements are commonly referred
to as deferred sales charges (DSCs). DSCs are structured so that the mutual fund distributor receives its sales
commissions upfront, even if its investors decide to pay the commission on a DSC basis.
In regards to the DSC payment option, it is important to note that the mutual fund manager is responsible for
financing the cash flow mismatch between the upfront sales commission payment to the distributor and the
incremental additional investment management fees that are charged to those investors who opted for this
payment option. DSC financing bridges the cash flow gap and it is the mutual fund manager’s responsibility to
arrange it as part of the fund’s distribution plans. The DSC payment option is usually structured so that it has no net
financial cost to the mutual fund manager. Accordingly, it does not become part of the new fund’s financial forecast.

SEED CAPITAL
New mutual funds require an initial investment of at least $150,000 in the underlying legal vehicle, which is usually
a trust but occasionally a corporation. This investment is referred to as the seed capital investment in the new fund,
and it is customary for this particular investment to be made with the fund manager’s capital.

THIRD-PARTY FEES AND EXPENSES

The operation of most types of investment funds and products includes the use of many different services. In
keeping with regulations and industry best practices, most of these services are provided by third parties — that is,
some party other than the fund manager. The primary services are as follows:
• Custodial/safekeeping
• Trustee
• Unitholder record-keeping
• Fund administrator
• Audit
• Legal
• Fund director fees (for those funds that have an independent board of trustees providing fund oversight)

Investment advisory and sub-advisory services are also performed by a third party. The fund’s investment advisor
is an independent legal entity, and its legal relationship with the fund is defined by the terms set forth in the
investment management agreement between the fund and the investment manager.
In most Canadian mutual fund companies, the fund manager and the fund’s investment manager, or portfolio
manager, are separate legal entities, but they are under the same control. On behalf of the mutual fund entity,
the fund manager must have a contract with the investment manager to obtain its services for the benefit of the
investors who own shares or units in the mutual fund entity.

INVESTMENT MANAGEMENT FEES

Investment management fees are fees paid by the mutual fund’s unitholders to its manager for portfolio
management, as well as any other administrative fees payable to the mutual fund manager that are not included in

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the third-party fees and expenses category. Essentially, investment management fees represent the fund manager’s
net revenue. This revenue attempts to compensate the manager for setting up the fund, providing investment
management, paying any ongoing trailer fees, paying for marketing and advertising, and (hopefully) earning a profit
for all of its efforts.
These fees are identified and quantified in the fund’s offering documents or prospectus. They are calculated on the
basis of a fixed percentage of the fund’s daily net asset value (NAV). Since the fees are charged directly to the fund
on a daily basis, they reduce the fund’s NAV by a similar amount. The fees can only be changed by a vote from the
fund’s current investors.
Investment management fees tend to be quite competitive between firms, though they do vary based on the type
of mandate a fund manages. Money market funds have the lowest investment management fees, bond funds have
the next-highest fees and equities have the highest fees of all three asset classes. Investment management fees are
highest for specialty mandate equity funds and those that invest in foreign markets.

PRO FORMA FINANCIAL PROJECTIONS

At this point, a pro forma financial projection is created for the new fund or product under consideration. It has
three key inputs or assumptions, as follows:
1. AUM (revenue)
2. Fees charged to investors (revenue)
3. All fees and expenses to be charged to the fund and, accordingly, to investors

These projections are prepared on an annual basis and they are normally made for five or more years. The fund’s
economics are usually based on two analyses, as follows:

Investor or Unitholder This analysis examines the total amount of fees and expenses that the fund will charge
annually. This is an important analysis, since investors have become more aware and
sensitive about the amount of money they are paying in fees and expenses. These annual
fees and the expenses associated with each Canadian mutual fund are readily available.
The information is usually expressed as a management expense ratio (MER). The MER
is charged to the fund by the fund manager before any returns are paid out to investors.
It includes the fund manager’s compensation and other expenses associated with
operating the fund. It is calculated as follows:
MER = (Management Fee + Fund Expenses) / Fund’s Daily NAV (10.1)

The MER is accessible from a number of sources since, by regulation, it must be included
in the fund’s routine financial reports. It is also published frequently by the fund manager
and is often included in the mutual fund section of newspapers and other publications
that focus on the mutual fund industry. The size of a fund’s MER is often part of a
potential investor’s decision as to which mutual fund to invest in.

Fund Manager This analysis examines the amount of fees the fund manager will earn from the fund
annually. In essence, this is the amount of money the fund manager will earn for creating
and managing the fund.

Although the amount of fees and expenses charged to a fund’s investors has become more important over
time, most fund managers attempt to launch a new fund with a competitive MER so that it is sold based on its
investment return potential and the fund manager’s expertise.

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As mentioned earlier, the key variable in the analysis of a fund’s pro forma financial projection is the amount of
AUM. Accordingly, the projection is normally prepared with a number of scenarios for sales or AUM. These scenarios
typically consider a series of different sales estimates.
A pro forma projection is essentially the final step in a new investment fund’s analysis before it goes for approval.

STEP SEVEN: OBTAINING APPROVAL FROM THE INVESTMENT

MANAGEMENT FIRM’S NEW PRODUCT DEVELOPMENT COMMITTEE
Once the analysis of the proposed new fund has been completed, the pro forma financial projection and all other
related materials are brought to the firm’s new product development committee, which is responsible for approval
and committing the resources required to take the final steps associated with creating and launching a new fund or
product.
The new product review will take the following key factors into consideration:

The Pro Forma The main focus will centre on the fees that are generated for the fund manager in
Financial Projection each of the scenarios for sales and AUM. The committee will agree to the expected or
probability-weighted sales scenario.

The Fund’s or product’s The new fund’s sales prospects will be examined by considering its uniqueness or
Competitiveness competitiveness, or both, and in terms of its investment manager’s capabilities.

The Marketing Strategy The committee will also examine whether the marketing strategy fits well with the
fund’s competitive aspects. If the fund has a unique investment strategy and mandate,
the committee will discuss the marketing message and how the market must be
educated about the fund. In the case of a “follow-on” fund, the committee will consider
how the market is likely to respond to one more fund in a sector that is already well-
developed.

Distribution The committee must be comfortable with the new fund’s distribution strategy. Does
the new fund sell itself, thereby making it appropriate for many different distribution
channels — that is, direct or advisory? Alternatively, is the new fund unique or very
specialized? Does the firm plan on using distributors that can effectively explain the new
fund to its investor base? The choice of distribution channels and partners is critical to
the new fund’s eventual sales success.

GO/NO-GO DECISION
The new product development committee’s review of the materials and information noted above leads to a
go/no-go decision.
Often the decision not to proceed any further with the development of a particular fund or product is made because
of concerns that it will not garner enough AUM to make it economical to create and manage. A new fund may be
cancelled if equity markets take a very bearish tone during the development process. It may also be cancelled or
postponed even after approval has been obtained and the fund manager has spent money on third-party services
to register the fund and prepare marketing materials. This seldom happens, but it can occur if equity markets
are particularly weak, which is not a favourable environment for any type of new fund launch. In this situation,
depending on the amount of money and resources expended, the fund manager may decide to complete all of
the necessary steps, such as prospectus completion, then resume the process once equity market conditions have
improved sufficiently.

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The decision to go, or proceed, with the new fund results in the development process moving forward to the next
step. Depending on the firm’s size, the new product development team might remain in charge of executing the
project up to and including the fund’s launch, or the responsibility might be transferred to another group.

DID YOU KNOW?

The Costs of Failure

Of course, not all new funds brought to market are considered a success. A number of factors can
hamper sales results, but weak market conditions in general, or weak conditions in the sector or
geographic areas that a new fund plans to invest in, can dampen potential investor interest if these
conditions are present around the timing of the new fund’s launch.
In these instances, the fund manager can experience two types of losses, as follows:
1. Direct financial loss, when the fund’s assets do not provide a return that covers the costs associated
with its launch.
2. Loss of marketplace stature, since market participants — competitors, independent distributors and
investors — are aware of the fund manager’s failure to create sufficient investor interest.
For large fund managers, the failure of a new fund launch does not have substantial consequences.
However, for small- to medium-sized firms, the potential risks associated with a new fund launch can be
of some concern. The failure of a new fund launch can make it potentially more difficult and expensive
for the small to medium-sized fund manager to launch a new fund in the future. Depending on the
reasons for the failure, fund distributors may be more reticent to join distribution syndicates for a small
to medium-sized firm’s future fund launches.

STEP EIGHT: DEVELOPING PROJECT MANAGEMENT TIMELINES

The decision to proceed and launch a new fund or product results in the transfer of future activities and associated
responsibilities to a project management committee, which is responsible for bringing the new product to
market after it has been approved by the new product development committee. In some investment firms, the two
committees are made up of the same personnel. In other firms, the project management committee consists of
individuals who are familiar with all of the activities required to actually create and launch the new product. Similar
to the new product development committee, the project management committee convenes when a new product
has been formally approved and meets on a periodic basis as the new product reaches key goals and deliverable
dates. The committee will then disband after the new product has been launched.
The project management committee’s primary responsibilities focus on enforcing the project management
guidelines and approved budget.

TIMELINE
The project management committee’s first task is to develop a timeline that will govern the project’s progress going
forward. This timeline includes all of the necessary deliverables, the resources required to complete each deliverable
and the dates when the individual deliverables must be completed.
For mutual funds, the period of time from when the go/no-go decision is made to the product launch will typically
be in the range of three to four months. As mentioned earlier, it typically takes four to eight weeks for the regulators
to review a mutual fund prospectus and its related distribution documents.
In the case of investment funds and products intended for the exempt or accredited investor markets, the process
is generally somewhat easier and takes less time to complete. The primary reason for this difference is that these
investment products do not require the preparation and filing of a prospectus, as well as the additional time

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associated with the necessary regulatory review. Investment products that target these types of investors can often
be ready for sale in less than two months.
Many of the steps in the project management process can be partially done in parallel with other steps. However,
a number of these steps are interdependent, and these dependencies must be correctly incorporated in the new
product development timeline. The following sections outline the various factors that must be taken into account
when preparing the timeline.

LEGAL STRUCTURE
One of the first steps is to establish the fund’s legal structure. This step is fairly straightforward and is done quickly,
since almost all of the other steps in the product development process depend on the existence of the fund’s legal
entity.

THIRD-PARTY SERVICE PROVIDERS

As mentioned earlier, the development and launch of a new investment fund or product involves a number of
services, most of which are provided by third parties that have expertise in various areas. Normally, established
mutual fund and institutional investment managers will select from existing third-party service providers to provide
the necessary services for the new fund. Hiring established contractors can shorten the period of time required to
seek, interview and negotiate contracts with new third-party service providers.
Also, many service providers will offer their services at competitive fees because of their existing relationship with
the manager of the new fund under development. These competitive fees also help make the fund’s expense load or
MER more competitive. This puts new fund managers at a slight disadvantage, since they will likely spend more time
and resources finding and negotiating with third-party service providers, and will unlikely negotiate a fee structure
as low as established fund managers receive for their funds and products. The project management process and
timeline must incorporate the time and resources needed to negotiate and contract different service providers —
typically, up to six — for a new investment fund or product.

DISTRIBUTION AGREEMENTS
Distribution agreements are required for most new investment funds or products. The only exception would be
investment management firms that distribute directly to exempt or accredited investors. Again, this process is very
straightforward and quick for established fund managers that have existing relationships with various third-party
distributors, as existing agreements usually only require straightforward amendments that accommodate the
addition of the new fund. Again, new managers are at a slight disadvantage time-wise, since they will have to source
and negotiate all of these agreements from scratch.
Distribution agreements cover many aspects of the relationship between the distributors and the fund manager.
Some of the key aspects and terms in a typical distribution agreement include the following:
• Fees and commission schedules
• Sales and marketing support for the fund manager, both in terms of sales and marketing materials, and
investment manager presentations and conference calls
• Advertising budgets and any co-sponsoring arrangements

REGULATORY FILING
Most investment firms and fund managers use the services of an external legal counsel for the preparation of all
of the documents and applications associated with filing a new investment fund or product offering. Therefore,
the legal counsel’s services must be negotiated so that they are available to meet the fund manager’s needs and
timeline. Depending on the time of year and the demand for external legal counsel, it may be prudent for the
committee to obtain an estimate of the counsel’s availability, even before making the go/no-go decision.

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Mutual fund prospectuses and offering memorandums or partnership agreements for exempt investment funds
and products can take four to six weeks to complete. Then, in the case of a prospectus, another four to eight weeks
are typically required for regulatory review. This is assuming that only a modest number of deficiencies appear in
the initial filing documents and that no — or only minor — waivers are being sought. It is generally wise to use
competent external legal counsel, since prospectus filings can contain many nuances that are most effectively and
efficiently addressed by lawyers who are very familiar with securities regulations and the regulatory review process
and standards. A new product launch date can be materially affected if filing documents with regulators are not
complete and prepared in the most comprehensive manner.

INTERNAL PREPARATIONS
As discussed in chapters 5 and 6, the fund manager and investment manager require numerous internal and
external information flows in order to sell and manage funds or products. This is a very straightforward process
when the new fund is an addition to an existing fund or product platform. However, modifications to these existing
processes and procedures are often necessary if the new fund’s mandate includes securities transactions in capital
markets, or investment dealers or custodians the fund manager or investment manager is not currently dealing
with. Existing procedures and processes have to be appropriately modified and adapted if the new fund’s mandate
involves the services of a sub-advisor with whom the fund manager does not currently have a business relationship.
These changes all point to the need for a pre-operational audit. This audit, which is discussed as part of the ninth
and final step in the new product development process, must be conducted before the new fund “goes live” and is
available for sale to investors.

STEP NINE: LAUNCHING THE PRODUCT

This final step in the product development process involves launching the new product. However, before the actual
product launches, there is still some work to be done, specifically a pre-operational audit and the implementation
of a sales and marketing strategy.

PRE-OPERATIONAL AUDIT
It is considered an industry best practice to conduct a thorough pre-operational audit of all systems and processes
before the launch of a new fund. The purpose of such an audit is to ensure that all operational aspects associated
with the sale and management of the new fund are functioning properly at industry standards.
This audit involves examining all of the fund manager’s front, middle and back office systems, plus the appropriate
systems of all other parties involved in the new fund’s distribution and management. These parties include the
fund’s investment managers, sub-advisors (if any), distributors, custodians, record-keepers and banks handling the
investors’ purchases and redemptions.
In essence, a pre-operational audit includes a “dry run” of all systems. Usually, a “dummy” sale of the new fund’s
shares/units is entered into the distribution fund sales system. This dummy sale and the “artificial” funds associated
with it are tracked through the distributor’s sales recording system and custodial bank accounts. In the next step,
the new fund’s sales information and artificial funds are then traced through to the fund manager’s internal systems,
as well as through those of the fund’s custodian and record-keeper. The funds then enter the investment manager’s
systems, where dummy investment transactions or trades are placed with the various investment dealers the
investment manager would deal with on the fund’s behalf. These dummy securities transactions are then traced
through to settlement with the fund’s custodian and fund administrator. Dummy securities sales transactions
are also performed and tested. In a similar manner, fund unitholder redemption requests are also processed and
audited.
The successful completion of the pre-operational audit is the only way to ensure that both the fund manager and
all third parties have operational processes and procedures that are operating at industry standards. For all parties,

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including the fund’s investors, the audit lowers the risks that can arise due to poorly designed or operated processes
and procedures, or both.
Well-designed systems that are properly operated help avoid errors or failures in procedures that can result in
financial losses for the fund manager due to “sloppy” operations. The fund manager’s reputation is also at significant
risk if it is not operating at industry standards and best practices, which a pre-operational audit will help avoid.

SALES AND MARKETING

Appropriate sales and marketing materials must be developed, prepared and published prior to a new fund launch.
Sales and marketing materials are prepared simultaneously for two audiences. The first audience is the distributors
that are contracted to sell the new fund. Specific materials are prepared to help them understand both the fund’s
mandate and the investment manager’s skills and abilities at managing such a mandate. The materials help them
prepare for how they will market the new fund to their respective clients or investors. In essence, these materials
help “script” the sales approach and discussion about the fund with prospective investors. These materials are
developed specifically for the appropriately licensed distributors and are not intended for distribution to investors.
The second audience is the prospective investors themselves. The materials normally take the form of glossy
sales and marketing brochures that fund managers, retail investment advisors or registered mutual fund sales
representatives send to individual investors. These brochures are an important and necessary part of the fund’s sales
process, particularly with individual investors — both mutual fund and exempt high-net-worth investors.
Print and media advertising is often part of the new fund launch and sales efforts. Sufficient time and resources
must be provided to arrange for advertising and to allow all preparations to be in place for the new product launch.
The distributors also want and need to be aware of the advertising strategy.
Finally, the fund manager must arrange for a road show just prior to the new fund’s launch. Road shows are
meetings in which the fund manager’s senior and regional sales and marketing staff and the new fund’s investment
manager make presentations to the distributors’ sales staff. These meetings typically last one to two hours and,
depending on the fund manager’s distribution strategy, can be held in a number of major cities across Canada.
Attendance varies by location and the distributors’ level of interest in the new fund offering. However, it is fairly
common for as many as 100 registered individual investment advisors or registered mutual fund salespersons to
attend a road show meeting.
The meeting agenda typically has two primary focuses. First, the fund manager’s sales and marketing staff will
explain the new fund’s marketing story, which include the following information:
• The fund or product’s unique features, if any
• A description of the investment mandate
• The uniqueness of the investment mandate and investment strategy
• The competitive positioning of the fund or product
• The investment manager’s capabilities
• The available sales and marketing support
• The advertising strategy
• The compensation and commission to the distributors

Second, the investment manager will make a presentation that explains their investment skills and abilities, and
how they will be used in the management of the new fund. Road shows are designed specifically to educate and
inform distributors about the new fund and its investment manager, and to create interest in and enthusiasm about
selling the fund.

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Due to the new fund road show’s focus on distributors, as well as the nature of the materials presented, the
attendance at a road show is restricted to appropriately licensed individuals. Accordingly, individual investors are
not permitted to attend.

INVESTMENT GUIDELINES AND RESTRICTIONS

Industry best practices require that each and every investment fund or product has its own unique set of approved
investment guidelines and restrictions that govern all aspects of the fund’s investment management. These
guidelines and restrictions are prepared during the new fund development process and are essentially agreed to
when the development of a new investment fund or product is approved.
The investment guidelines and restrictions must be consistent with the fund’s stated investment objectives and
accommodate all regulatory restrictions that pertain to the fund’s investment activity. Though they are not
intended to be modified on a frequent basis, the investment guidelines and restrictions pertaining to each and every
fund should be reviewed on an annual basis. Any and all changes to the investment guidelines and restrictions must
be approved by the parties with the fiduciary duty for the particular fund.
Investment guidelines and restrictions are intended to ensure the fund meets its long-term objectives. It is wise for
the firm that is launching a new product or fund to employ agreed-upon restrictions that govern the investment
manager’s actions with regard to the fund. These guidelines and restrictions permit the investment manager to use
their skills and abilities to manage the fund, but only within the parameters that are considered appropriate by the
fiduciaries responsible for the fund’s operation and management.
Consistent with industry best practices, all investment guidelines and restrictions are monitored on a real-time
basis by personnel who do not report to the investment manager or front office staff. The compliance staff, who are
part of the firm’s middle office operations, perform this monitoring function (see Chapter 6).
Numerous benefits can accrue from having a well-defined investment policy for each investment fund. Some of the
primary benefits are as follows:

Improves Portfolio Well-developed investment guidelines and restrictions help to minimize the frequency
Return Consistency and amount of deviation between the fund’s return and the periodic rate of return of
its peers and competition. The fund’s significant underperformance in relation to the
performance of its peers should be reduced. (Unfortunately, when the guidelines and
restrictions are well-developed, they will also reduce the frequency and amount of
outperformance for the fund relative to its peers). Any reduction in the volatility of the
fund’s returns should result in higher and more favourable risk-return statistics for the
fund.

Higher Fund Sales and Normally, investment funds with the most favourable risk-return statistics are able to
AUM garner greater market share over time. Of course, a higher AUM leads to a higher level of
investment management fee income for the fund’s investment manager.

Reduces Potential For two reasons, the potential volatility reduction in the fund’s periodic returns should
Litigation be accompanied by a reduction in the potential for litigation from investors during
periods of very poor market returns. First, the fund experiences a decrease in its NAV to a
lesser degree than its peers, who manage similar mandates but with wider and higher-
risk investment guidelines and restrictions. Second, investment funds that are managed
within prudent investment guidelines and actions do represent industry best practices,
providing less opportunity for successful claims against the fund or investment manager.

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COMMON DESIGN FACTORS FOR INVESTMENT GUIDELINES AND

RESTRICTIONS
A number of factors are taken into consideration when designing a set of investment guidelines and restrictions that
govern the investment management of a new fund or product.
By their nature, equity-focused funds will, of course, have some unique guidelines and restrictions, as will fixed
income and money market–focused funds. Balanced fund mandates will have investment guidelines and restrictions
that specifically pertain to overall equity and fixed income portions, and to specific equity and fixed income security
allotments.
Discussed below are a number of design factors that are common for both equity and fixed income investment
mandates.

INVESTMENT OBJECTIVES
All investment funds and products should have a concise statement of their investment objectives. This statement
is important and useful for both fund distributors and investors, because it helps to assess the degree of risk
associated with investing in a fund. As a general rule, those funds that only seek capital appreciation tend to have
greater investment risk than those that also pursue earning income. By defining a fund’s investment objectives, it is
easier to make a proper comparison with its competitors.

PASSIVE VERSUS ACTIVE MANAGEMENT

As mentioned in Chapter 7, funds with passive investment management strategies have continued to grow in
popularity among both individual and institutional investors. The majority of investment firms and fund managers
tend to provide investment funds and products based on one investment management style — that is, either active
or passive, but not both.

DOMESTIC VERSUS GLOBAL FOCUS

A fund’s geographic focus and the countries it is permitted to invest in are of great importance to investors. The
various capital markets around the world offer different investment opportunities and also carry different risks.
These are very important considerations for investors and their advisors.
It is common for a mutual fund manager or a large institutional investment manager to offer funds with a complete
domestic focus, funds with a complete international focus and, often, funds with a global focus. As a result, the
manager hopes to have access to more investors since it is, in essence, offering the entire range of investment
products from a geographic perspective.
Properly structured investment guidelines and restrictions will normally stipulate the minimum and maximum
amount of the fund’s assets that can be invested in each country or general geographic region. These restrictions
ensure that the fund will be managed according to its stated mandate and that it does not become overexposed to
any particular country’s or region’s financial markets due to the relative outperformance of those particular markets.
In equity markets, these particular diversification guidelines are typically built around the equity market indexes for
global capital markets that are prepared by companies such as Standard & Poor’s.

ONSHORE VERSUS OFFSHORE REGISTRATION

Onshore versus offshore refers to where an investment fund or product is registered. As such, it is a product design
feature and is often associated with income tax and other related potential benefits. Offshore funds can bring along
other types of risks for investors, as the legal and regulatory requirements that govern the offshore legal entity
that is holding the investments might be quite different from those that exist in the investor’s country of domicile.
However, the choice of a fund’s registration and domicile does not tend to affect its investment strategy per se.

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INTERNAL VERSUS EXTERNAL INVESTMENT MANAGEMENT

The majority of institutional investment managers manage all of their funds or mandates exclusively using internal
investment management staff. On the other hand, some mutual fund managers may offer a limited number of
investment funds where external investment managers are used on a sub-advisory basis to manage a particular fund
or portion of a fund.
In the case of a fund with a very narrow investment mandate, such as one that only invests in one foreign country
or a small foreign geographic area, the sub-advisor will be responsible for the entire fund. For other investment
products with a broader investment mandate, such as a global equity or global fixed income fund, the fund manager
might use the services of a number of external investment managers, with each of them responsible for managing a
predetermined portion of the fund’s total assets.

PORTFOLIO MANAGEMENT STYLE

Equity investment managers tend to focus on one investment management style. The most popular investment
management styles are as follows:
• Growth
• Value
• Momentum
• Growth at a reasonable price (GARP)
• Technical

Although, strictly speaking, investment management style is not part of the investment guidelines and restrictions,
it is a critical aspect of an investor’s decision to invest in a particular fund. Investment management style is usually
one of the key attributes used to describe a fund’s investment management approach. Style provides a broad-brush
description of the investment management approach. However, a description of style is usually accompanied by a
more detailed explanation of how an investment manager actually executes a fund’s investment strategy and makes
investment decisions. The detailed explanation is meant to let the investor know how a manager is different — and
hopefully better — than competing managers who are grouped under the same investment style.
Investment management style is important because many investors and their advisors have definite preferences
for a particular style. This preference is often a starting point when making a decision to invest with a new fund
manager.
In response to this style preference, some fund managers offer an investment fund or product with a blended style
approach that makes use of a number of external investment managers on a sub-advisory basis, with each of them
managing a predetermined portion of the fund.

PORTFOLIO REBALANCING FREQUENCY

Due to the nature of the capital markets and the different performance of securities, an investment fund’s actual
investment exposure changes constantly and, depending on the markets, can result in material changes to the
fund’s investment exposures. This typically occurs when a particular sector of the market for a small group of
securities had a substantially different performance than the market or the rest of the fund’s securities.
On a real-time basis, the investment manager constantly monitors the fund’s exposure, typically as a percentage
of its total market value. As the market value weighting of individual securities, market sectors or even entire
asset classes, as in the case of balanced funds, approach their respective predetermined limits, the manager must
rebalance the fund’s holdings. Rebalancing must be done in order for the fund’s investments to be closer to the
manager’s “target” portfolio and also to remain within the fund’s investment guidelines and restrictions.
Rebalancing processes and procedures are driven by the competing forces of trying to keep a fund’s risk profile as
similar to the selected benchmark or index as possible, and trying to keep the rebalancing activities themselves to

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a minimum. This is the case because every rebalancing transaction incurs additional transaction costs of brokerage
and custodial fees.
When rebalancing, all investment managers use proprietary investment models, which attempt to obtain the
optimal financial result for the fund given the two competing factors. Depending on their optimization models,
every manager will use different rebalancing frequencies and drift ranges from the benchmark.

SECTOR RESTRICTIONS
Sector guidelines stipulate the minimum and maximum weight exposure that a fund can have, as compared to the
market value weighting of the respective sectors in the fund’s performance benchmark.

EXAMPLE
Assume that a particular industry sector currently has a 15% market value weighting on the S&P/TSX 60 Index,
which is Fund A’s performance benchmark. Fund A’s investment guidelines state this sector’s maximum market
value variation from the 15% weighting established by the performance benchmark. Suppose the guidelines
state that the sector could not vary by more than plus or minus 3% from the performance benchmark’s sector
weighting. Fund A’s sector weighting would have to be rebalanced if its respective market value percentage
breached 12% on the low side or 18% on the upside.

This risk control tool helps ensure that the fund does not become over- or underexposed on any sector weighting
versus the weighting of the same sector in the fund’s performance benchmark or index.

ISSUER RESTRICTIONS
Sector restrictions manage risk by controlling the amount of money that may be invested in a particular sector in a
fund. Similarly, there are diversification guidelines to control the amount invested in a specific security issuer. Issuer
restrictions add one more level of refinement to risk control for the entire portfolio.
There are two primary types of issuer-based guidelines. One type restricts the number of issuers that a fund can
hold at any time, while the other specifies the maximum percentage of a fund’s NAV that can be invested in any one
issuer. These guidelines are generally set as either:
• A maximum percentage variation from an issuer’s market value weight in a fund’s benchmark; or
• A market value percentage weight for an issuer in terms of its market value percentage weight in a fund.

Issuer guidelines are established in a similar method as sector guidelines.

EXAMPLE
Suppose that Company B currently represents a 3% weighting on a market value basis of the S&P/TSX 60 Index,
which is the fund’s performance benchmark. Also, assume that the fund’s investment guidelines and restrictions
state that a specific issuer’s market value weighting cannot be greater than 150% of the company’s current
weighting in the index. This means that the maximum allowed weighting of Company B’s value in the fund
would be 4.5%.

Issuer restrictions are normally set in terms of maximum allowable investments to control the maximum amount
of the fund that can be invested in any one issuer. However, though investment managers normally do not include
minimum investment restrictions pertaining to individual issuers, there are indirect guidelines contained within the
investment restrictions pertaining to the minimum allowable investment in an industry sector.
Some investment guidelines and restrictions also include a requirement that there is a cap on the fund’s investment
as a fixed percentage of the fund’s assets in any one issuer, regardless of that particular issuer’s market value
weighting in the index. This type of guideline surfaced in the late 1990s when the market value of one stock, Nortel
Networks, grew to more than 20% of the market capitalization of the entire Toronto Stock Exchange Index.

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At the time, many investors and fiduciaries were uncomfortable in allowing the permissible investment in Nortel
to approximate this exposure in their portfolios. Many fiduciaries decided to put a “hard” cap weight on Nortel,
irrespective of its actual weighting at the time. This practice became so prevalent that, at the time, the Toronto
Stock Exchange Index was modified to include a sub-index that placed a fixed maximum weighting on that
particular issuer’s market value.
It is important to note that some investment guidelines and restrictions stipulate that a fund must hold a minimum
number of issuers at all times. This stipulation is intended to complement the maximum issuer restrictions
discussed above.

UNIQUE FACTORS IN EQUITY MANDATE DESIGN

Due to the nature of equities versus other asset classes, such as fixed income, investment guidelines and restrictions
for equity mandates contain a number of unique factors.

CAPITALIZATION
Equity mandates are normally designed and examined in terms of the allowable capitalization issuers included in
a fund. Equities are normally segmented into large-, mid- and small-capitalization categories. These categories are
important since investors and investment advisors need to understand the amount of risk that a particular equity
mandate is likely to incur due to the size of the companies the fund invests in. However, the precise definition of
these categories and the market value ranges allowed for each are not generally agreed upon in the investment
marketplace.
As a result, it is important that a fund’s investment guidelines and restrictions clearly define, numerically, the
allowable ranges of capitalization for its individual issuers. One rule of thumb is that small-capitalization equities
and some foreign equities offer greater potential returns over time, but they are normally accompanied by greater
risk because a fund’s NAV will become more volatile.

SECTOR- OR INDUSTRY-SPECIFIC FUNDS

In the particular case of a sector- or industry-focused equity investment mandate, only the accepted and
conventional industry categories are used in the design of its mandate and in the construction of its investment
guidelines and restrictions. Also, the investment guidelines and restrictions for an industry-focused equity fund
must include a restriction on the maximum allowable proportion of the fund that can be invested in equity
securities that do not form part of the sector index. Of course, the firm must also set restrictions regarding the
maximum allowable exposure to any one issuer in the sector or industry index that pertains to the fund.

DIVIDEND-YIELDING SECURITIES
Where appropriate, investment guidelines and restrictions for an equity mandate include a restriction regarding
the minimum amount of the fund’s assets that can be invested in dividend-paying equities at all points in time.
This restriction is particularly important if the fund’s investment objectives include earning income. It is also often
included to direct a specified minimum amount of the fund’s investments into issuers with less perceived risk
because of their dividend-paying history.
Of course, this restriction is not normally included or applicable for sector-specific funds that, by virtue of their
mandate, invest in economic sectors that are still in their infancy or normally more focused on retaining capital
for internal purposes, rather than returning part of their earnings each year to current shareholders. For example,
this restriction would probably not apply to sector-specific funds that focus their investments in areas such as
biotechnology or research-intensive industries, like some sectors of the information technology market.

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CASH AND SHORT-TERM INVESTMENTS

Investing guidelines and restrictions for an equity mandate often include restrictions on the amount of cash that the
fund can hold. The percentage of cash allowed depends on the fund’s investment objectives. If the fund seeks high
absolute returns, it may be allowed to hold 10%, 20% or more in cash. A liberal restriction on cash holdings gives
the manager room to tactically allocate assets. If the fund is more sensitive to a stock’s benchmark weight, cash
may be restricted to no more than 1% to 2% of the fund’s total value.

NON-COMMON STOCK INVESTMENTS

Depending on an equity mandate’s design, its investment guidelines and restrictions may allow for investments
in securities other than common stocks, cash and short-term instruments. Some of the more common types of
allowable securities for equity funds are warrants, options and convertible bonds.
The vast majority of equity mandates allow investments only in the common stocks of equity market issuers. Some
equity mandates do permit investments in related securities, but they are restricted to a maximum market value
percentage of the fund. In turn, each type of non-equity security will have a maximum allowable investment for
that type of security. Finally, each type of non-equity security will also have investment guidelines and restrictions
that stipulate a minimum amount of diversification of the issuers within each and every type of non-equity security.

COVERED CALL WRITING

One strategy that is used to increase a fund’s income or risk profile is covered call writing. Covered call writing
involves the writing or sale of call options against some of the long positions or underlying common stock held
by a fund. In this type of transaction, the investment manager is seeking to increase the fund’s income by earning
premiums related to the sale of the call options, while accepting the risk that the common stock held by the fund
might be called away at a fixed price to the call option’s buyer.
The additional income the fund earns by selling the call options is considered in light of the trade-off that would
occur if the common stock were to achieve a sufficiently high enough price in the future that it would be called
away at the option strike price. In that scenario, the fund would lose an opportunity to earn the amount above the
strike price at which the securities were sold to the call option’s owner. Investment guidelines and restrictions on
many equity mandates do permit a limited amount of covered call writing when the investment manager deems
it appropriate. It is not uncommon for funds with this type of flexibility not to use covered call writing strategies
during strong bull markets.
It is extremely important to note that in the case of Canadian mutual funds, call writing must be done only on a
covered basis, wherein the amount of common stock underlying the amount of written or sold options is held on
a continuous basis until the options expire or are called. Selling options without owning the amount of underlying
common stock is commonly referred to as naked call writing and, by regulation, is explicitly not permitted within
mutual funds.

SHORT SALES
Regulations pertaining to Canadian mutual funds permit a fund to sell securities short. Short selling is limited to
20% of a fund’s NAV.

CURRENCY HEDGING
For an equity mandate that permits a portion or all of the fund’s assets to be invested in securities issued in non-
domestic markets, there will be a foreign currency risk exposure. This is the case because the fund’s NAV is generally
calculated in Canadian dollars, while some or all of its securities are trading and priced in other currencies.
The decision as to whether or not the portfolio manager will employ currency hedging or partial currency hedging is
part of the product design. However, the fund’s investment guidelines and restrictions must be consistent with the
selected currency hedging strategy.

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PERFORMANCE BENCHMARKS
As discussed in Chapter 5, an investment manager’s performance is measured by two standard methods. For an
institutional investment manager in particular, their performance is primarily assessed relative to other active
managers who are managing a similar investment mandate. These particular managers and their institutional clients
are focused on the investment manager’s percentile ranking.
For mutual funds, market-based indexes are often used as a performance benchmark. It is important that the
correct market index or indexes be used when explaining a fund’s performance. The market index that is selected
should be representative of the fund’s investment objectives, investment strategy, and investment guidelines and
restrictions.
Occasionally, a fund will rely on a custom-made index for its particular mandate — if such an index is more
appropriate than a standard benchmark. The investment firm should carefully explain the methodology behind
the construction of the custom index so that the fund’s distributors and investors will better understand the fund’s
investment objectives and investment strategy.

UNIQUE FACTORS IN FIXED INCOME MANDATE DESIGN

Due to the unique features of fixed income securities, investment guidelines and restrictions for fixed income
mandates contain a number of unique factors.

SECTOR-SPECIFIC MANDATES
The majority of fixed income mandates are offered on the basis of broad fixed income market exposure. These funds
constitute the majority of AUM in the fixed income fund marketplace.
However, there is an interest in fixed income funds with sector-specific mandates. The most popular sector-specific
funds are those that only invest in the following:
• Government securities (federal, provincial and municipal)
• Corporate securities (only investment-grade)
• Specialty securities (mortgage-backed securities and asset-backed securities — see Chapter 8)

Sector-specific fixed income mandates are very popular, particularly in the United States. Canadian investors,
particularly institutional investors, are becoming more comfortable with investing in sector-specific funds, usually
as a supplement to the bulk of their fixed income assets that are invested in funds based on broad fixed income
market mandates.

CREDIT QUALITY
Fixed income mandates are also defined by the lowest allowable credit quality rating of the issuers of the fixed
income securities in which the funds are able to invest. The vast majority of broad market and specialty fixed income
mandates only permit investments in issuers with an investment-grade credit quality rating. An investment-grade
credit quality rating means that the issuers of the fixed income securities have, at a minimum, a BBB credit quality
rating from at least one of the popular fixed income credit rating agencies.
Fixed income securities with a credit quality rating below investment grade are often referred to as junk bonds.
As noted above, the investment guidelines and restrictions for broad market fixed income mandates do not
normally permit investments in junk bonds. There is market interest in well-designed and diversified fixed income
portfolios that only invest in securities that are below investment grade. These particular fixed income mandates are
commonly referred to as junk bond funds. They constitute a very small percentage of the total AUM of fixed income
funds and tend to be most popular in the U.S.

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Regardless of whether a fixed income mandate is restricted to investment-grade issuers, investment guidelines
generally include restrictions on the entire fund’s minimum average credit rating, as well as on the maximum
percentage of the fund’s assets that can be invested in securities with various credit ratings.

EXAMPLE
For an investment-grade fixed income fund, the credit quality restrictions might stipulate that a minimum of
60% of its NAV be invested in securities with an AAA credit rating, a maximum of 20% of its NAV be invested
in securities with an A credit quality rating and a maximum of 10% of its NAV be invested in securities with
a BBB credit quality rating. Of course, in addition, the investment guidelines and restrictions would prohibit
investments in fixed income securities that carry a credit rating below BBB — that is, of junk bond status.

TERM TO MATURITY
Even fixed income funds that are completely invested in AAA government-issued securities can expose investors
to significant capital risk, particularly if interest rates rise substantially from the time of the original investment.
By their nature, fixed income securities have varying amounts of interest rate risk, which increases as the term to
maturity, or duration, of the securities increases.
Accordingly, the investment guidelines and restrictions must restrict a fixed income fund’s minimum and maximum
average term to maturity, or average duration. This is particularly important in the case of broad market fixed
income funds, where the term to maturity for investments can range from as short as one to two weeks (for money
market investments) to as long as 30 years (for securities issued by federal and provincial governments).
Some fixed income mandates are designed specifically around term-to-maturity restrictions and attempt to provide
investments that are centred on the short-, mid- or long-term sectors of the broad fixed income market. For this
type of fixed income fund, the investment guidelines and restrictions also limit the amount by which the fund’s
average term to maturity may deviate from the representative term to maturity for the sector of the broad fixed
income market in which it is investing.

CURRENCY HEDGING
In Canada, most fixed income funds only invest in fixed income securities issued by domestic issuers. Accordingly,
there is seldom any foreign currency exposure for these types of funds. To the extent that a fixed income fund is
allowed to invest a maximum percentage of its NAV in foreign securities, the investment guidelines and restrictions
will be developed in a manner that is consistent with the currency risk stipulated in the fund’s design.

PERFORMANCE BENCHMARK
A number of market-based indexes exist for domestic and global fixed income markets. These indexes are also
further broken down into bond market sector indexes, and even bond market sub-sector indexes. They help measure
the performance of fixed income investment managers, providing information about the industry’s characteristics,
such as term to maturity, credit quality and coupon. But, most importantly, the rates of return, which are divided
into capital and interest income, are available for these indexes.

UNIQUE FACTORS IN BALANCED FUND MANDATES

Balanced funds form a significant portion of the total amount of AUM for both individual and institutional investors.
Virtually all mutual fund managers and institutional investment managers offer a balanced fund mandate in
addition to the various other equity and fixed income funds they manage and offer.
Normally, a balanced fund’s equity and fixed income portions are invested in a manner identical to that in which
the fund manager’s or institutional investment manager’s diversified equity funds and diversified bond funds are
invested. A balanced fund will accomplish this in one of two ways. It will hold individual securities in the balanced

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fund in the same proportion as they are held in the equity and bond funds, or simply invest in units of the entire
equity and bond funds.

TARGET ASSET MIX POLICY

In offering a balanced fund to investors, a fund manager is also offering their expertise in determining the fund’s
appropriate asset mix. For balanced funds, asset mix decisions are substantially different than those for equity
funds and fixed income funds, as the investment manager uses different skills and abilities when determining the
appropriate mix between equities, fixed income securities and cash.
The investment guidelines and restrictions for a balanced fund’s equity and fixed income portions are invariably
the same as the ones that apply to equity and fixed income funds. However, additional investment guidelines and
restrictions are required to limit the entire fund’s asset mix policy. Specifically, they stipulate the minimum and
maximum amount of the balanced fund’s NAV that can be invested in the three major asset classes — namely,
equities, bonds and cash.
An investment manager typically manages a balanced fund relative to a target asset mix policy, which represents
the fund’s average or long-term asset mix.
For a typical Canadian balanced fund, the target asset mix policy is as follows:
• 60% Canadian equities
• 30% Canadian bonds
• 10% Canadian short-term money market investments

The target asset mix is unique to each balanced fund. Balanced fund mandates can have a target equity mix from
50% to 70% of the fund’s assets. The remainder of the fund’s assets is normally invested in Canadian fixed income
securities.

STRATEGIC VERSUS TACTICAL ASSET MIX STRATEGY

For a balanced fund, the target asset mix is often also described as the strategic asset mix policy. An investment
manager attempts to add value to a fund over time by adjusting its strategic asset mix in order to capture perceived
opportunities in one asset class versus another. These adjustments, which are based on analysis and models that
the investment manager develops, typically indicate when one asset class is cheap or expensive relative to the other
asset classes the balanced fund can invest in.
This active management strategy, which is applied to managing balanced funds, is commonly referred to as the
tactical asset mix strategy. Investment guidelines and restrictions limit the degree to which a balanced fund’s
tactical asset mix strategy can change the market value weightings of various asset classes from the weightings
established in the target asset mix policy for these asset classes.

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SUMMARY
After completing this chapter, you should be able to:
1. Describe the key steps for analyzing the potential for investment products and developing new ones.
There are nine key steps in assessing and developing new investment products:
1. Identifying potential market opportunities
2. Determining the required portfolio management skills, and if external investment management skills will
be needed
3. Assessing the market
4. Determining the legal and regulatory restrictions
5. Developing a marketing and distribution strategy
6. Preparing a financial forecast, including pro forma financial statements
7. Obtaining approval from the investment management firm’s new product development committee
8. Developing project management timelines
9. Launching the product

2. Discuss the importance of a thorough assessment for a new investment product’s potential market size and
the challenges of developing that assessment.
Assessing investor needs is very important and can result in an incredibly large market opportunity if they
are assessed properly and the product’s design accommodates them.
It is a very difficult and challenging activity to gauge or assess investor demand, since the demand is
dependent on a number of factors. Some of the more important factors are as follows:
« The general tone of the capital markets, particularly equities.
« The overall performance of the particular capital market sector if the new mandate is especially focused.
« The firm’s investment performance in both its absolute return and its performance relative to the capital
market sector the new fund is focused on.
« The adequacy of a firm’s distribution efforts.

3. Describe the various legal and regulatory issues when considering the development of a new investment
product.
A prospectus must be filed with each of the provincial securities regulators where the mutual fund will be
distributed.
In Canada, investment products, such as hedge funds, private equity funds and leveraged buyout funds,
that are only designed for and distributed to exempt or accredited investors do not require an approved
prospectus. They are generally distributed with an offering memorandum or a partnership agreement, or
both.

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 CHAPTER 10 | CREATING NEW PORTFOLIO MANAGEMENT MANDATES 10 • 29

4. Identify the key information requirements for preparing a financial forecast for a new investment product.
The financial forecast integrates the product development team’s assumptions about the following key
variables:
« Sales volumes
« Distributor compensation, including upfront commissions and trailer fees
« Seed capital requirements
« Third-party expenses
« Investment management fees
The pro forma financial projection has three key inputs or assumptions, as follows:
1. AUM (revenue)
2. Fees charged to investors (revenue)
3. All fees and expenses to be charged to the fund and, accordingly, to investors

5. Explain the steps to follow after project approval has been granted for a new investment product.
Step seven is obtaining project approval from the investment management firm’s new product development
committee. If the project is approved, it moves forward to the next step, which is step 8.
Step eight: Developing project management timelines
« Develop a timeline that will govern the project’s progress.
« Establish the new fund’s legal structure.
« Negotiate with and contract different third-party service providers.
« Complete regulatory filings.
« Establish internal and external information flows in order to sell and manage the new fund or product.
Step 9: Launch the product
« Conduct a thorough pre-operational audit of all systems and processes before the launch of a new fund.
« Appropriate sales and marketing materials must be developed, prepared and published prior to the
product launch.

6. Describe the purpose of an investment product’s investment guidelines and restrictions, and the critical
importance of having a well-defined investment policy.
Investment guidelines and restrictions are intended to ensure the fund meets its long-term objectives.
These guidelines and restrictions permit the investment manager to use their skills and abilities to manage
the fund, but only within the parameters that are considered appropriate by the fiduciaries responsible for
the fund’s operation and management.
Some of the primary benefits of having a well-defined investment policy are improved return consistency,
higher fund sales and assets under management (AUM), and reduced potential litigation.

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 Alternative Investments 11

CONTENT AREAS

Definition of Alternative Investments

Reasons to Invest in Alternative Investments

Issues and Challenges with Alternative Investments

Performance Attribution

Unique Risks of Alternative Investments

Due Diligence

Current Trends and Developments in Alternative Investing

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LEARNING OBJECTIVES

1 | List the primary characteristics and attributes of alternative investments.

2 | Explain the main factors for the continued and growing interest in alternative investments.

3 | Describe some of the major issues and challenges an alternative investment manager must deal with
and why they must be dealt with properly.

4 | Describe how the asset allocation process is used and modified when alternative investments are
included in a portfolio’s asset mix.

5 | Identify some of the main problems and issues that arise when doing performance attribution for
alternative investments.

6 | List and describe some of the unique key risks of alternative investments and why they must be
considered prior to investing in them.

7 | Describe the due diligence process when thinking about investing in an alternative investment.

8 | Discuss the primary trends and developments in the alternative investment management industry
and their potential impact on its development.

KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

alternative investments liquidity dates

commodities lockup

directional strategies managed futures fund

due diligence modern portfolio theory (MPT)

efficient frontier private equity

event-driven strategies real estate

fund of hedge funds (FoHF) relative value strategies

hedge funds transparency risk

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 CHAPTER 11 | ALTERNATIVE INVESTMENTS 11 • 3

INTRODUCTION
Traditionally, an investment fund’s board of trustees would have focused their investment efforts on publicly traded
securities, such as equities and bonds. However, with uncertain equity market returns and lower prospective bond
market returns, many institutional investors have shifted their attention from the public investment markets to
alternative investment markets.

DEFINITION OF ALTERNATIVE INVESTMENTS

An investment is generally considered alternative if it meets the following criteria:
• Has different performance characteristics from traditional assets, such as stocks and bonds — that is,
alternative investments do not conform to the normal or bell-shaped return distribution that is typical of
traditional investments
• Is rarely traded in public capital markets
• Is relatively illiquid, when compared to marketable securities
• Is relatively uncommon in investment portfolios
• Has a relatively limited investment history
• Requires unconventional investment skills on the part of an investment manager

By comparison, traditional investments have historically comprised equities, bonds and money market investments
that are traded in public capital markets and invested on a long-only basis. Traditional investments can be easily
benchmarked for performance measurement and are managed by strategies that do not involve short selling,
leverage or the use of derivatives.
Alternative investments cover a wide range of investment opportunities. The major categories include hedge funds,
private equity, real estate and commodities (see Figure 11.1).

Figure 11.1 | Major Alternative Investment Categories

Alternative
Investments

Hedge Funds Private Equity Real Estate Commodities

Arbitrage Venture Capital Private Real Estate Physical Commodities

Event-Driven Distressed Debt Public Real Estate Managed Futures
Long-Short Equity Mezzanine
Multi-Strategy Funds Leveraged Buyouts
(Funds of Hedge Funds) (LBOs)

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HEDGE FUNDS
Hedge funds are lightly regulated pools of capital whose managers have great flexibility in their investment
strategies. These strategies are often referred to as alternative investment strategies. However, this term may
also be used to describe investments in private equity, real estate, commodities or managed futures. Hedge
fund managers are not constrained by the rules that apply to mutual funds or commodity pools. They have no
restrictions on short positions, use derivatives for leverage and speculation, perform arbitrage transactions and
invest in almost any situation in any market where they see an opportunity to achieve positive returns.
Because hedge fund managers have tremendous flexibility in the types of strategies they can employ, the manager’s
skills, including the ability to select superior investments within the targeted strategy and relevant markets, is more
important for hedge funds than for almost any other managed product.
Some hedge funds are conservative, while others are more aggressive. Despite the name, some funds do not hedge
their positions at all. Therefore, it is best to think of a hedge fund as a type of fund structure, rather than as a
particular investment strategy.

COMPARING HEDGE FUNDS TO MUTUAL FUNDS

Like mutual funds, hedge funds have the following characteristics:
• They are pooled investments that may have front-end or back-end sales commissions;
• They charge management fees; and
• They can be bought and sold through an investment dealer.

Despite these similarities, there are many differences between mutual funds and hedge funds, as summarized in
Table 11.1 below.

Table 11.1 | Comparing Mutual Funds to Hedge Funds

Mutual Funds Hedge Funds

Can take limited short positions Have no restrictions on short positions

Can use derivatives only in a limited way Can use derivatives in any way

Are usually liquid May have liquidity restrictions

Are sold by prospectus to the general public Are generally sold by offering memorandum to
accredited investors only

Are subject to considerable regulatory oversight As private offerings, are subject to less regulations

Charge management fees, but usually have no Charge management fees and, in most cases,
performance fees performance fees

Have a “relative” return objective — that is, performance Have an “absolute” return objective — that is, the fund
is usually measured against a particular benchmark is expected to make a profit under all market conditions

Most are valued daily Most are valued monthly

Performance is disclosed quarterly or annually to Performance is disclosed annually to unitholders

unitholders

Cannot take concentrated positions in a single issuer’s Can take concentrated positions
securities

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HEDGE FUND STRATEGIES

While there are many different hedge fund strategies, there is no standardized industry classification for hedge
funds. However, hedge funds can generally be broken down into three major categories based on the strategies they
use — relative value, event-driven and directional. These are described below in order of increasing expected return
and risk.
1. Relative value strategies attempt to profit by exploiting inefficiencies or arbitrage opportunities in the pricing
of related stocks, bonds or derivatives. Hedge funds using these strategies generally have low or no exposure
to the underlying market direction.
2. Event-driven strategies seek to profit from unique events, such as mergers, acquisitions, stock splits and
buybacks. Hedge funds using event-driven strategies have medium exposure to the underlying market
direction.
3. Directional strategies bet on anticipated movements in the market prices of equity securities, debt securities,
foreign currencies and commodities. Hedge funds using these strategies have high exposure to trends in the
underlying market.

Table 11.2 shows these three major categories of hedge fund strategies and the specific strategies that fall within
each category.

Table 11.2 | Major Hedge Fund Categories

Relative Value Strategies Event-Driven Strategies Directional Strategies

(Low Exposure to (Medium Exposure to (High Exposure to

Market Direction) Market Direction) Market Direction)

• Equity market neutral • Merger or risk arbitrage • Long/short equity

• Convertible arbitrage • Distressed securities • Global macro
• Fixed income arbitrage • High-yield bond • Emerging markets
• Dedicated short bias

RELATIVE VALUE STRATEGIES

EQUITY MARKET NEUTRAL
An equity market neutral strategy exploits equity market inefficiencies and opportunities by creating simultaneously
long and short matched equity portfolios of approximately the same size. The goal of equity market neutral
investing is to generate returns that do not depend on the stock market’s direction. Well-designed equity market
neutral portfolios hedge out the risks related to industry, sector, market capitalization, currency and other
exposures. Leverage is applied to enhance returns.

EXAMPLE
A manager may use sophisticated computer screening tools and security analysis to assemble a $120 million
diversified basket of long equity investments in companies with superior growth, returns on capital and earnings
trends. To hedge the long exposure, the manager shorts a $120 million similarly diversified basket of stocks in
companies with slowing growth, returns on capital and earnings trends.

CONVERTIBLE ARBITRAGE
A convertible arbitrage strategy identifies and exploits the mispricing between convertible securities, such as
convertible bonds or preferred shares, and the underlying stock. Convertible securities have a theoretical value that

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is based on a number of factors, including the underlying stock’s value. When a convertible bond’s trading price
moves away from its theoretical value, an arbitrage opportunity exists.
This strategy typically involves buying undervalued convertible securities and hedging some or all of the underlying
equity risk by selling short an appropriate amount of the issuer’s common shares. When properly executed, this
strategy creates a net position with an attractive yield that is almost completely unaffected by broader equity
market movements. Interest income on the convertible bond, added to the interest on the short sale proceeds,
contributes a relatively steady return.
With convertible bonds, there are additional opportunities for gains, which are independent of market conditions,
as the relative value relationship between the long bond and short stock changes. Convertible bond prices typically
behave like equity prices when the issuer’s common shares rise well above the conversion price, which is the stock
price at which a bond’s value can be converted into an equivalent number of common shares. Likewise, a convertible
bond behaves more like a regular bond when the issuer’s common shares decline well below the conversion price.
When the shares fall below the threshold, the bond trades on its investment value — that is, its value as a bond
without a conversion feature. This value is based on the general level of interest rates and the issuer’s perceived
creditworthiness.
In a declining stock market with rising interest rates, a fund that is long a convertible bond and short a common
stock could realize a gain on the short stock position that exceeds the loss on the bond. Although the bond’s value
may change, it cannot fall below its investment value. In a rising stock market with falling interest rates, the gain
from the bond should be greater than the loss on the stock, because the amount of stock that is sold short is nearly
always less than the conversion amount. Given the low-risk nature of convertible bond arbitrage, leverage is used to
enhance results.
One of the keys to this strategy is determining the appropriate hedge ratio and rebalancing the trade as the value of
the equity changes, making convertible arbitrage an art as well as a science. In reality, the return would be affected
by transaction costs, bid-ask spreads that reflect market liquidity, potential changes in the bond’s investment value
(which is a function of interest rates and credit spreads), financing costs on the bond, and any short sale fees or
restrictions. The manager has to be nimble to exploit such an opportunity and must constantly monitor the position
to ensure that the expected price relationship between the bond and the stock holds.

FIXED INCOME ARBITRAGE

A fixed income arbitrage strategy attempts to profit from price anomalies between related interest rate securities
and derivatives, including government and non-government bonds, mortgage-backed securities, options, swaps and
forward rate agreements. Because the price anomalies are very small in value, high leverage is normally used to help
generate returns well beyond the transaction costs. Leverage for this type of fund can range from 10 to 30 times the
capital employed.

EVENT-DRIVEN STRATEGIES
MERGER OR RISK ARBITRAGE
A merger or risk arbitrage strategy invests simultaneously in long and short positions in the common stock of
companies involved in a proposed merger or acquisition. The strategy generally involves taking a long position in the
company being acquired and a short position in the acquiring company. The hedge fund manager attempts to take
advantage of the differential between the target company’s share price and the offering price. Typically, the target
company’s share price increases after a takeover or merger announcement, but it does not rise to the full offering
price because of the risk that the deal may not close.
The returns on merger arbitrage are largely uncorrelated to the overall stock market. In general, equity risk is
managed because the hedge fund manager deals with the probable outcomes of specific transactions, rather than
with predicting the overall market.

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EXAMPLE
ABC makes an offer to acquire XYZ for $50 per share, a 25% premium to its current price, payable in stock. ABC’s
stock fell a couple of percent on the news, to $10 per share, because the acquisition would be slightly dilutive
to its earnings per share this year and only modestly accretive to next year’s earnings. Risk arbitrageurs shorted
five shares of ABC for each one share they acquired of XYZ (Hedge ratio = XYZ $50 share price / ABC $10 share
price = 5). Because the deal is subject to regulatory review and shareholder approval, XYZ is trading at only $48
per share, which is a 4% discount to the hedged $50 transaction value. Assuming six months to completion, this
represents an annualized return of over 8% that a risk arbitrage fund would typically seek to improve by using
leverage.

DISTRESSED SECURITIES
A distressed securities strategy invests in the equity or debt securities of companies that are in financial difficulty
and face bankruptcy or reorganization. Distressed securities generally sell at deep discounts, reflecting their issuers’
weak credit quality. Many institutional investors are not permitted to own securities rated less than investment
grade. Therefore, downgrading the credit rating of an issuer or security to below the permissible minimum can
precipitate a wave of forced selling that depresses the security’s value below fair market value. Hedge fund
managers attempt to profit from the market’s lack of understanding of the true value of deeply discounted
securities or the inability of institutional and other investors to hold these securities.

HIGH-YIELD BONDS
A high-yield bond strategy invests in high-yield debt securities, which are also known as junk bonds, of a company
that a manager believes may get a credit upgrade or is a potential takeover target. In general, these funds use little
or no leverage.

DIRECTIONAL STRATEGIES
LONG/SHORT EQUITY
The long/short equity strategy is the most popular type of hedge fund strategy, constituting more than 75% of
Canada’s hedge fund activity. These funds are classified as directional funds, because the manager has either a net
long or net short exposure to the stock market. The manager is not trying to eliminate market effects or trends
completely, as would be the case with an equity market neutral strategy. Rather, the manager is taking both long
and short positions simultaneously, depending on the outlook of specific securities.
With a long/short equity strategy, managers try to buy stocks they feel will rise more in a bull market than the
overall market, and sell short stocks that will rise less. In a down market, good short selections are expected to
decline more than the market, and good long selections will fall less.
In a long/short equity strategy, the fund is exposed to market risk based on the extent of the net exposure, which
is either long or short. Compared to a long-only fund, this type of fund is often better able to profit in a declining
market, as it can short stocks and manage the fund’s net exposure to the market. The amount of leverage used is
usually modest and rarely more than three or four times the capital employed. Most of these types of funds use
smaller amounts.

GLOBAL MACRO
The global macro strategy is one of the most highly publicized hedge fund strategies, although it constitutes only a
small percentage of the strategies used by today’s hedge funds. Its popularity is due to high-profile managers, such
as George Soros and Julian Robertson, who in the past earned spectacular returns on well-publicized macro events.
Rather than make investments on events that affect only specific companies, funds that use a global macro strategy
make bets on major events affecting entire economies, such as shifts in government policy that alter interest rates,
thereby affecting currency, stock and bond markets.

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Global macro funds participate in all major markets, including equities, bonds, currencies and commodities. They
use leverage, often through derivatives, to accentuate the impact of market moves.

EMERGING MARKETS
Emerging markets hedge funds invest in equity and debt securities of companies based in emerging markets. The
primary difference between an emerging markets hedge fund and an emerging markets mutual fund is the hedge
fund’s ability to use derivatives, short selling and other complex investment strategies. However, since some
emerging markets do not allow short selling and do not have viable derivatives markets, these funds may not be
able to hedge. As a result, their performance can be very volatile.

DEDICATED SHORT BIAS

To be classified as short bias, the fund’s net position must always be short. In other words, the fund may have long
positions, but on a net basis, it must constantly be short.
One of the better-known short bias funds, which was closed out because of a continued increase in stock prices, was
run by Julian Robertson of Tiger Management. Throughout most of the late 1990s, his fund was short several billion
dollars’ worth of technology stocks. He finally closed out the fund in early 2000 following the continued run-up in
the NASDAQ Composite Index. Unfortunately, his timing could not have been worse. Shortly after closing out his
fund, the NASDAQ Composite Index began its rapid descent as the “high-flying” technology-related sector of the
market experienced a significant decline. In retrospect, if the fund and its investment strategy had remained in place
for one year longer, the fund’s investors would have stood to make over a 60% rate of return.

FUNDS OF HEDGE FUNDS

A fund of hedge funds (FoHF) is a portfolio of hedge funds overseen by a manager who determines which hedge
funds to invest in and how much to invest in each. There are two main types of FoHF, as follows:
1. Single-strategy, multi-manager funds, which invest in several funds that employ a similar strategy, such as
long/short equity funds or convertible arbitrage funds.
2. Multi-strategy, multi-manager funds, which invest in several funds that employ different strategies.

Funds of hedge funds have the following advantages:

Due Diligence The task of selecting and monitoring hedge funds managers is time-consuming and
requires specialized analytical skills and tools. Most individual and institutional investors
do not have the time or the expertise to conduct thorough due diligence and ongoing
risk monitoring for hedge funds. FoHFs constitute an effective way to outsource this
function.

Reduced Volatility By investing in a number of different hedge funds, a FoHF should provide more
consistent returns with lower volatility or risk than any of its underlying funds.

Professional An experienced portfolio manager and their team evaluate the strategies employed
Management by the various fund managers and establish the appropriate mix of strategies for the
fund. Selecting funds that make up a low- or non-correlated portfolio requires detailed
analysis and substantial due diligence. Ongoing monitoring is also required on each
underlying fund to ensure performance objectives continue to be met.

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Access to Hedge Funds Most hedge funds do not advertise and many are not sold through traditional
distribution channels. Information on some hedge funds is closely held and hard to
access. Many successful hedge funds have reached their capacity limitations and either
do not accept new money or accept money only from existing investors. Using their
experience and contacts within the industry, reputable FoHF managers will know how to
contact a hedge fund manager or obtain information on a particular fund, and are even
able to reserve capacity with a fund. These are important qualities that a FoHF manager
brings to the table.

Ability to Diversify FoHFs increase smaller investors’ access to hedge funds. While there are many Canadian
with a Smaller hedge funds that accept as little as $25,000 from accredited investors, some funds have
Investment a minimum investment threshold of US$1 million, with some as high as US$5 million
or more. An investor would need to commit significant funds to achieve the equivalent
diversification offered by a FoHF.

Manager and Business Because hedge funds are less regulated than more mainstream investments, many
Risk Control investors believe that some hedge fund management firms may terminate their activities
for business or other reasons at any time. This risk is based on the fact that hedge fund
management firms tend to have relatively small business concerns, and their success
often relies upon one or a small number of managers and partners. Moreover, some
hedge funds pursue riskier investment strategies and may be more likely to experience
problems, with some likelihood of having to terminate the fund. This “blow-up risk”
can be diversified away through a FoHF, as any individual fund likely represents only a
relatively small fraction of the total assets invested. Additionally, the FoHF manager’s
duty is to continuously monitor and manage underlying funds in order to mitigate
business risk.

For these reasons, FoHFs are increasingly the preferred hedge fund investment for both institutional and retail
investors.
However, FoHFs do have certain disadvantages and risks, as follows:

Additional Costs Competent FoHF managers can be expensive to retain. Additional fees cover the
management and operating expenses of the FoHF organization as well as its margins.
Most FoHFs charge a base fee and an incentive fee, in addition to the fees — both base
and incentive — charged for the underlying hedge funds. A typical FoHF charges a 1%
management fee and a 10% incentive fee, plus fund expenses.

No Guarantee of FoHFs do not constitute guaranteed investments and may not meet their investment
Positive Returns objectives. In fact, during certain periods, a FoHF’s asset values will probably decline.
Investors and advisors need to understand that a FoHF is simply the sum of its
component hedge fund investments. Despite the claims of some hedge fund marketers,
investors should not, and cannot, expect positive returns in every reporting period.

Low or No Strategy Some FoHFs are strategy-specific and invest only in one type of hedge fund, such as a
Diversification long/short equity or convertible arbitrage. Such FoHFs fill a specific role in a portfolio
and may contribute less diversification than other multi-strategy, multi-manager FoHFs.

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Insufficient The number of hedge funds in a FoHF can vary dramatically, from five to more than
or Excessive 100. Some may not provide adequate diversification, depending on the objectives the
Diversification investor is seeking. Others may dilute returns and provide more diversification than the
investor needs.

Additional Sources of To enhance their return potential, some FoHFs add a second layer of leverage above the
Leverage leverage used by the underlying hedge fund managers. This adds to a FoHF’s costs and
risks, and needs to be understood and agreed upon by the investor.

COMMODITIES
Commodities are another class of alternative investments. Investments in commodities can be made in two
primary ways:
1. Directly: By buying and selling commodities
2. Indirectly: Through commodity derivatives — that is, futures, forwards or swaps

Although it is less direct, exposure to commodities can be had by investing in the securities of companies that
produce commodities.
Commodities are considered a separate asset class, since they can offer diversification benefits when combined
with a traditional portfolio that contains equities and bonds. They often display high volatility, as well as a negative
correlation with equity and bond returns, and a positive correlation with inflation.
In portfolios where income is a high priority, a direct investment in commodities is generally not suitable, since
they do not provide any interim cash flows, unlike bonds, which provide interest income, or some common equities,
which provide dividends. The only return on a commodity investment comes from changes in the commodity’s
price.
One form of indirect investment in commodities is through a structured product design commonly referred to
as a commodity-linked note. This type of note generally offers a small amount of periodic income in addition to
realizing, in the form of capital gains, some portion of the underlying commodities’ price change. However, these
notes do not have a large market share. The most popular method of commodity investment is through a pooled
fund vehicle called a managed futures fund.

MANAGED FUTURES FUNDS

A managed futures fund invests in listed financial and commodity futures markets and currency markets around
the world. Fund managers are usually called commodity trading advisors (CTAs).
Most managers of managed futures funds apply a systematic approach to trading, using technical and statistical
analyses of price and volume information to determine investment decisions. Once the manager has developed the
system, trading decisions are largely mechanical and little or no discretion is involved. Other fund managers make
discretionary decisions according to current economic and political fundamentals.
In Canada, managed futures funds are often established as commodity pools. Based on National Instrument 81-104,
these commodity pools can be sold as mutual funds to the general investor and use derivatives in a leveraged
manner for speculation. However, regulators require greater disclosure and higher proficiency from the mutual fund
companies and the agents that sell these products, compared to what they require of those that sell conventional
mutual funds.

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PRIVATE EQUITY
Private equity denotes equity investments that are not actively traded on public markets. Although these
investments are not listed on a public exchange, they represent shares of an asset. As such, they are similar to
publicly listed shares or units. A company may choose to raise capital in the private market for many reasons, often
because its business is in its infancy or to save some time or cost — or both — in raising capital.
Private equity is a rapidly growing market and is typically done through funds structured as limited partnerships
(LPs). The promoters are the general partners, while the investors are the limited partners. Funds may be primary,
where a round of financing is raised for first-time investing in different opportunities, or secondary, where the funds
invest by buying back positions held by primary investors needing to liquidate earlier than the maturity date.
Private equity investments include leveraged buyouts, mezzanine capital, venture capital and infrastructure
investments.

LEVERAGED BUYOUTS
A leveraged buyout (LBO) occurs when the buyer of the majority of a company’s shares finances this purchase
through debt, often with the acquired company’s assets being used as collateral for the loan. LBO firms represent
some of the wealthiest finance organizations anywhere, and have the ability to raise funds above $10 billion and
conduct multi-billion dollar deals. LBO funds are structured as LPs, with the general partners, who are the fund’s
promoters, receiving ongoing compensation, and the limited partners receiving returns that are contingent on
investment performance.

MEZZANINE CAPITAL
A firm may wish to finance by floating high-yielding unsecured preferred equity or subordinated loans. Typically,
this mezzanine capital is just above common stocks in seniority. As such, it is a comparatively costly way for firms
to raise capital. From a private equity investor’s point of view, the risk of default is about the highest in the debt
spectrum, but the investment pays high returns in compensation for the higher credit risk.

VENTURE CAPITAL
Venture capital is applied to the financing of new, untested companies and business ventures. It also helps finance
growing early stage companies, which are not yet mature or not ready to issue equity or debt in the mainstream
markets, or struggling companies, in which case the investment is called distressed investing. Because of the high
risks involved, venture capitalists require the potential for very high returns and fully diversify their portfolios
to offset the likelihood that several funded companies will terminate operations or some business projects will
not reach the market. Importantly, before investing, venture capitalists require that the company present a clear
exit strategy, showing how the venture capitalist will be able to divest their investment, either through an initial
public offering (IPO) or acquisition. Venture capital is perhaps best known for its role in financing technology and
biotechnology projects, and bringing to market some of the largest corporations in business today.

INFRASTRUCTURE
Investments in infrastructure represent massive amounts of capital with a small number of investing partners.
Infrastructure refers to such projects as roads, ports, airports and waterworks. In Australia, Europe and North
America, there is a rapidly growing demand for private financing of public projects. A well-known Canadian example
is the 407 Express Toll Route in Toronto. The worldwide infrastructure market has been reserved for very largest
institutional investors, such as the Caisse de dépôt et placement du Québec’s ownership stake in Heathrow Airport
Holdings Ltd. Infrastructure investing is highly illiquid and long-dated.

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Exhibit 11.1 | Summary of Private Equity Features

The following points summarize the features of private equity:

• Private equity fund shares are illiquid, with no specific resale markets, although increases in secondary funds
create greater opportunity for reselling positions.
• Liquidity is low, as typical investment maturities are in the range of seven to 10 years, and often longer.
• Private equity investments typically have a higher risk-return profile, with significant default, counterparty and
manager risk. For example, the success of a venture capital project, directly depends on key personnel remaining
with the venture.
• The attraction of private equity is that, on average, it has shown long-term returns that are significantly greater
than traditional equity returns, although with higher volatility.
• Private equity investing is often by invitation, and opportunities may be restricted to seasoned investors.
• Because of long holding periods, private equity investing can be a stable part of a portfolio, because adverse
market events will not lead to liquidation and market timing will be less of a factor. Long maturity favours a
more consistent average rate of return.
• Because risk-return levels tend to be high, the role of private equity in a portfolio is as an equity substitute or as
a satellite or complementary position around a more conservative core position.
• Investment minimums are high and are typically outside the range of most private investors. The development
of lower minimum funds will likely allow more high-net-worth investors to participate.

REAL ESTATE
Real estate is considered an alternative investment even though it has been an important investment for
countless investors over thousands of years. However, from the point of view of financial markets and the portfolio
management industry, real estate is seen as an alternative to traditional investments, such as stocks and bonds.
Investment in real estate equity tends to take two forms: private and public (also referred to as real estate
securities). With the private form, investments are made in real, tangible assets that usually generate steady cash
flow from rental income. Generally, investors access real assets through pooled investment vehicles or some other
type of commingled fund. The real estate market is segmented into commercial, industrial and residential sectors.
Equity real estate, both private and public, can offer favourable risk-return characteristics and low correlations
with traditional investments. Beyond low correlations with other types of asset classes, real estate also offers
diversification benefits across geographic regions and types of real estate properties. Many investors hold physical
real estate in the form of primary or secondary residences, or as investment properties.
Physical real estate has several distinguishing features, as follows:
• The average retail investor will feel comfortable leveraging real estate, as opposed to shorting or margining
investments. Real estate is arguably the single most important collateralized asset owned by investors. Other
types of property can be leveraged as well.
• Similar to other investment fees, real estate investment costs can be high.
• Appraisal, due diligence, maintenance and repair costs all reduce an investment’s return and need to be factored
into the potential net returns that property can generate.
• Tax liabilities can be significant with real estate. In particular, municipal taxes, water taxes, school taxes and
other taxes levied on the value of property or at disposition need to be considered.
• Real estate may represent a significant portion of an investor’s total net worth. Because of this, when
completing asset allocation, an advisor should, whenever possible, include real estate holdings in their analysis.

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• Real estate market returns compete with other asset market returns. At the same time, real estate provides
current consumption value, which other investments may not. The implicit rental value of property needs to be
taken into account, as it represents an opportunity cost of holding and occupying physical real estate.
• Real estate is positively correlated with inflation and tends to protect a client’s net worth from the erosion of
inflation.
• With potentially long holding periods, real estate — depending on the type and purpose of the investment —
can stabilize overall portfolio returns, although it can be highly volatile. Real estate markets are subject to
boom-and-bust cycles.
• Overall, real estate can be considered a bond substitute with an added inflation protection feature.

Real estate holdings are not interchangeable; are expensive per unit; and require significant management, care and
maintenance. For these reasons, many investors will not physically hold real estate beyond a principal residence
and perhaps a secondary one. Real estate has been structured into investment vehicles that pool property holdings
under one sponsorship and management, and then resell shares of the pool to investors. Investors hold claim to the
net returns generated by the pool, pro rata to their share proportion. This is called securitization, which has proven
popular in the form of real estate investment trusts (REITs).
Real estate takes a public form when it is securitized — that is, when a pool of real estate assets is resold to investors
as shares, as in the case of REITs. Real estate securities can provide exposure to good property expertise and a
diversified set of properties, and are considerably more liquid and divisible than actual real estate holdings.
REITs have been successful in the recent past. The following are some of their main features:
• REITs are publicly traded, with most of them listed on the Toronto Stock Exchange. Hence, they are liquid and
can be traded much more readily than their physical counterparts.
• REITs have shown a high and stable average rate of return, which has made them attractive to many investors.
• REITs offer tax efficiency, because they flow profits back to investors to be taxed in their hands (under their
individual tax conditions).
• REITs tend to be more correlated to equities than to bonds, as their sensitivity to macroeconomic factors and
overall economic health is similar to stocks.
• From an asset allocation point of view, REITs tend to be construed as a high-yield bond or equity substitute.
Their liquidity makes them less stable than physical real estate and contributes to making their market value
significantly more volatile.

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Exhibit 11.2 | Summary of Alternative Investment Features

Although each alternative asset class offers unique benefits and drawbacks, the broader group shares a number of
common features, including the following:
• The potential for higher risk-adjusted returns than traditional asset classes
• A relatively low correlation to traditional investments
• Less liquidity than traditional investments
• Limited performance history and benchmark availability
• No trading in transparent public markets across most alternative sectors
• Relatively infrequent transactions, and returns that are dependent on private valuation
• Less regulation than traditional investments
• The ability to use leverage, short securities and derivatives
• Higher investment management–related fees
• A longer capital lockup period and investment horizon
• Narrow (as yet) availability to individual investors

Some of these characteristics clearly do not apply to all alternative asset classes. For example, many hedge funds
generally invest exclusively in publicly traded securities that are priced daily. Real estate investment will not involve
the shorting of a stock. However, in general, the above features hold for most alternative asset classes.

REASONS TO INVEST IN ALTERNATIVE INVESTMENTS

Since the 1990s, both individual and institutional investors have become more interested in alternative investments.
However, the level of interest and investment in alternative investments has particularly grown in momentum since
the turn of the new millennium. The sharp technology-led sell-off in the global equity markets in 2000, coupled
with the low yields available on bond investments at the time, encouraged many investors to shift a portion of
their investments in traditional asset classes, such as public equities and bonds, into different forms of alternative
investments.
Why is there so much interest in alternative investments? By their nature, alternative investments offer a number of
potential benefits that are neither characteristic of nor present in traditional investments. The following summarizes
these potential benefits:

Table 11.3 | The Potential Benefits of Alternative Investments

Benefit Description

They Offer Improved The return characteristics of alternative investments differ from those of traditional
Portfolio Diversification asset classes, and vary widely within the group of alternative investments. Since
their periodic returns are uncorrelated with traditional equity and fixed income,
alternative investments can diminish overall portfolio risk.

They Can Realize Through short sales, some alternative investment strategies, such as hedge funds,
Profit in Any Economic can realize profits even in weak economic or financial market environments when
Environment securities are declining in price.

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Table 11.3 | The Potential Benefits of Alternative Investments

Benefit Description
They Reduce Portfolio An overall investment portfolio’s volatility can be reduced when alternative
Volatility investments are properly combined with traditional assets or other types of
alternative investments. The volatility of a traditional portfolio comprised of only
equities and bonds can be reduced by the addition of alternative investments.
Accordingly, the portfolio’s current equity and bond holdings can be maintained.

They Enhance Long-term Often, alternative investments are added to a portfolio to potentially increase its
Total Risk-adjusted risk-adjusted return over the long term. Many investment managers use alternative
Returns investments even if doing so means a lower potential rate of return. This is the case
as long as the lower rate of return will be accompanied by an even greater reduction
in the portfolio’s potential risk, which is usually measured in terms of the standard
deviation of returns.

Investors Gain Access to Many investors have the majority of their investment portfolios invested in
Investment Managers traditional assets. These portfolios are managed by investment managers who
(and Investment have expertise investing in publicly traded securities. Furthermore, these portfolios
Strategies) that Are Not are invested in a long-only manner. Investing in alternative investments exposes
Generally Available to investors to managers with very different skills and investment strategies. It is hoped
the Public that this access provides better investment results over the long term.

They Preserve Capital in A unique feature of alternative investments, particularly hedge funds, is they can
Volatile Markets be used in a number of trading strategies, such as short selling and the use of
derivatives. These particular investment strategies are seldom used in traditional
long-only portfolios, but have the benefit of producing positive returns, regardless of
the direction of the overall financial markets.

They Provide Access Some alternative investment strategies focus on global markets and securities that
to Global Markets a traditional equity and bond portfolio would not normally invest in. Investments in
these markets would likely only occur through alternative investments.

They Align with The managers of alternative investment funds receive a large portion of their
Investors’ Interests variable compensation from a standard performance fee calculation that is based
Through Variable on the amount of returns or gains their fund earns or realizes. Accordingly, the
Performance Fees investment manager receives a performance fee only if their alternative investment
fund earns a positive rate of return. Intuitively, the performance-fee basis of variable
compensation has a closer alignment with investors’ interests. This is the case
because the manager of an alternative investment only receives a performance fee if
they actually increase the value of the investor’s fund holdings.

They Align the Interests The managers of alternative investment portfolios often have a significant portion of
of investors with Those their personal wealth invested in the funds they manage, which more closely aligns
of Investment Managers their interests with those of investors. In contrast, those who manage traditional
portfolios might have little, if any, of their personal wealth invested in the equity,
bond or money market portfolio they are responsible for.

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ISSUES AND CHALLENGES WITH ALTERNATIVE INVESTMENTS

There are a number of issues and challenges associated with investing in alternative investments. There are well-
accepted processes and procedures developed to deal effectively with each of these issues, but they nonetheless
represent a potential operational challenge and risk, particularly to those start-up alternative investment managers
whose previous experience primarily involved managing and investing in traditional investments on a long-only basis.

ASSET ALLOCATION PROCESS

One of the major challenges institutional investors face when evaluating alternative investments is determining the
appropriate asset allocation policy, including which alternative investments to include in the policy portfolio and in
what proportions.
Typically, the analysis of policy mix alternatives is based on historic periodic return data for each asset class under
examination. It is tempting to use historical pricing data for the analysis of an asset mix policy simply because
the data is available. This approach is acceptable for conventional assets, which are frequently traded and have
observable market price data, and for which it is correctly assumed that the forward-looking period is adequately
represented by historical pricing and the rate of return data set. However, there are a number of considerations that
limit their use in determining asset mix policy allocations.
In order to have an appropriate and accurate analysis, it is imperative that the risk and rate of return data and
assumptions used in the analysis of the asset mix policy across traditional and alternative investments be forward-
looking and consistent in reflecting the true underlying economic exposure of the assets. Historical data can be
biased on both accounts and therefore may affect — in some cases, perhaps severely — the validity of the asset mix
policy analysis.

MEAN-VARIANCE OPTIMIZATION
For the purposes of determining the asset mix policy allocation, whether for traditional or alternative investments,
it is appropriate to use long-term risk and return characteristics. These estimates should never be conditional on the
current or near-term market and business cycle situation, but must instead focus on the characteristics relevant to
the portfolio over a long time horizon.
The distinct performance characteristics of various alternative investments provide a rationale for including
them in a multi-asset portfolio. However, it is hard to quantitatively gauge the optimal share of such alternative
investments. Across many of the liquid and publicly traded asset classes, the use of quantitative mean-variance
models has become routine, with the most widely used being based on Markowitz’s modern portfolio theory
(MPT).1 The basic theory behind MPT contends that a portfolio’s diversification across different asset classes with
low or negative correlation characteristics will minimize risk. The quantitatively derived asset allocation parameters
seem to provide investors with a method of constructing optimal and efficient portfolios.
However, investment managers who use MPT or other quantitative asset allocation methods in alternative
investment sectors face considerable hurdles. These types of asset allocation models make strong assumptions
about market structure, statistical pricing dynamics, the use and dispersion of pricing data, and investor behaviour.
These assumptions generally imply that mean variance optimization should result in risk-minimizing portfolios for
rational investors.
This theory works surprisingly well for portfolios constructed of highly liquid public markets, such as common
stocks and bonds. However, alternative investments are another matter. Alternative investments do not conform
well to many of the key assumptions underlying standard mean-variance optimization. First, one of the strongest
assumptions is that the asset returns are normally distributed, which is certainly not the case for most alternative
asset classes. Most alternative assets do not follow a symmetric bell-shaped distribution, such as a normal

1
Harry M. Markowitz, “Portfolio Selection,” The Journal of Finance 7, No. 1 (March 1952): 77–91.

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distribution. Indeed, most alternative asset classes tend to be skewed and characterized by significant kurtosis.
Skewness and kurtosis are two statistical measures of the variation of the asset class returns from a normal
distribution. They essentially attempt to quantify how far the asset class rate of return distribution varies from a
normal distribution.
Often, MPT performs poorly when asset returns are skewed, resulting in an efficient frontier — a set of optimal
portfolios that match an investor’s expected returns with their risk tolerance — that systematically includes smaller
allocations to negatively skewed assets for a given level of returns than is optimal. Second, the implied symmetry
of the covariance-based measure of risk ignores investor risk aversion. The usual mean-variance approach treats
return deviations from the mean (expected return) in a symmetrical fashion — that is, unexpectedly high returns
are considered just as sub-optimal as unexpectedly low returns. In reality, investors are undeniably more averse to
volatility on the downside than to volatility on the upside.
These limitations, and others, result in the limited validity of using pure mean-variance models, such as MPT, to
determine the optimal portfolio asset allocation to alternative investments. Unfortunately, the available data sets
on alternative investments are generally not yet sufficiently robust or precise to support highly targeted asset
allocation decisions.
Pioneering research done by professors in the U.K. has resulted in a solution to this asset mix policy conundrum
when alternative asset classes are considered in a portfolio’s asset mix. Their analysis concludes that MPT-type
quantitative models can be used, but with modification, so that the optimization algorithm includes the skewness
measure and the kurtosis measure for each asset class under consideration. So, in essence, they attempt to preserve
MPT and its strong theoretical underpinnings, and adjust it to accommodate the abnormal aspects of the return
distributions for non-traditional asset classes, such as alternative investments.2, 3, 4

SECURITY PRICING AND VALUATION

Security pricing is very straightforward for funds that invest solely in publicly traded securities. It is generally as
simple as obtaining a daily end-of-day data feed from the stock exchange or exchanges on which a fund’s securities
are traded.
However, for the vast majority of investments made by alternative investment managers, there is no equivalent
independent and accurate source of security pricing. In fact, security pricing for unlisted and non-marketable
securities and assets is often a mix of art and science, and sometimes the art component can lead to serious issues
for a fund and its investors. Alternative investment managers should ensure they have developed and instituted
a security pricing process that is sound, reasonable and appropriate for the specific types of securities and
investments their fund will invest in.
Furthermore, investment managers should strive to ensure that a fund’s investors also have a clear understanding of
the pricing risks generally associated with the periodic valuation of the types of securities and investments included
in the fund.

SHORT SALES
Some start-up hedge fund managers and their administrative staff have limited experience executing and settling
security short sale transactions. In the case of a long sale, the fund actually owns the stock that is being sold.
However, in the case of a short sale, the manager must make arrangements for a broker to borrow the stock that

2
Harry M. Kat, “Managed Futures and Hedge Funds: A Match Made in Heaven,” Alternative Investments Research Centre Working Paper Series,
Working Paper #0014, London, UK.
3
Gaurav S. Amin and Harry M. Kat, “Stocks, Bonds and Hedge Funds: Not a Free Lunch!” Alternative Investments Research Centre Working
Paper Series, Working Paper #0009, London, UK.
4
Chris Brooks and Harry M. Kat, “The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors,” Alternative
Investments Research Centre Working Paper Series, Working Paper #0004, London, UK.

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the fund has sold short, so that this particular stock can be “lent” to the fund, then delivered to the party that
purchased it from the fund. These arrangements can introduce an operational risk for the investment management
firm, as well as for the fund and its investors.
Care must be taken to ensure that the firm’s front, middle and back office staff fully understand the execution,
settlement and accounting of securities that the fund has sold short. Most investment dealers and prime brokers
have daily processes and procedures to ensure that all of their clients — that is, investors and fund managers — have
properly settled their short-sale transactions on a timely and daily basis.
It is imperative that all of an investment manager’s fund accounting reports identify all of a fund’s long and short
positions accurately and on a daily basis.

ACCOUNTING FOR LEVERAGE

Financing, or the use of financial leverage, is key in many types of alternative investment strategies, especially
hedge fund strategies. As will be discussed in detail later in this chapter, most hedge fund financing is short term, at
variable rates and can be called in on one day’s notice. The investment management firm must always be aware of
the amount of leverage in each of its funds. This information should ideally be available on a real-time basis, since
the amount of leverage in many hedge funds changes throughout the day as trading occurs. In addition to knowing
exactly how much leverage they are currently using, the manager must also be sure that the amount of leverage
being used in the management of each individual fund is within the bounds allowed by investment guidelines and
restrictions. In addition, the manager must also be aware of how much leverage the prime broker or brokers allow
for each particular fund the manager oversees.
It is also critical for the manager to have real-time information about the margin balances for each of the funds
they manage. Margin balances are a measure of the amount of financing or credit available for each fund. These are
calculated by prime brokers and investment dealers on a daily basis for all of the accounts they have with margin
agreements in place. Accounting for margin balances can become an exercise in consolidation, since a fund might
have more than one source of margin credit available and active at any one time.

PERFORMANCE ATTRIBUTION
Performance attribution is the process whereby a fund’s periodic performance results are analyzed to determine
its various “sources” of return. Numerous commercially available performance attribution models exist and many
investment managers supplement them with some of their own additional refinements. Performance attribution
is relatively straightforward for funds that contain only traditional investments, such as publicly traded stocks and
bonds.
However, the performance attribution process becomes much more difficult when analyzing alternative investment
funds. As noted earlier in this chapter, many alternative investment funds contain primarily investments or
securities that are not publicly traded and for which there are no available realistic and independently sourced
values or prices. Therefore, the valuation and pricing of a fund’s investments are left to the abilities and judgement
of its investment manager. The validity of the performance attribution exercise can be severely affected by this
subjective security pricing process. Although generally well-meaning, the manager has no way of determining
whether the pricing of the portfolio’s securities are realistic or not. Unrealistic security pricing leads to an inaccurate
valuation of the fund’s net asset value (NAV), and an inaccurate valuation of the NAV leads to inaccurate rate of
return calculations, which means the performance attribution will also be inaccurate. The end result is that the
fund’s valuation, performance measurement and reporting, and performance attribution processes are rendered
meaningless.

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LACK OF SUITABLE PERFORMANCE BENCHMARKS

For investment products that invest solely in publicly traded securities, such as mutual funds, there is a plethora
of suitable performance benchmarks available to help investors assess the success and capabilities of a mutual
fund manager. Unfortunately, this is not necessarily the case in the alternative investment management industry.
However, third-party performance index providers do exist for alternative investment mandates. For example, in
the hedge fund industry, there are more than 10 firms that provide hedge fund performance indexes and associated
information. Most of these firms provide monthly performance data series to the public on either a free or fee-
for-service basis. However, these firms have their own unique assumptions and standards for developing and
maintaining their databases and performance data series. Those who consult these performance data series must be
cognizant of the assumptions and procedures that are used to develop and maintain this information.
One of the biggest challenges for performance index providers is that fund universe participants — that is, fund
managers — provide their respective fund and return information on a voluntary basis, so anyone and everyone
can participate. Most of the performance index providers do not have filters or processes to ensure that only the
appropriate investment funds are being included in their respective performance universes and sub-universes.
Also, performance data for most alternative investment funds is not audited or verified by an independent party
or auditor. Accordingly, there is no assurance that the data investment managers submit to performance index
providers is accurate and truthful.

LACK OF MANDATE DEFINITION AND STANDARDIZATION

Another significant challenge for performance index providers, as well as investors, is that there are no industry-
wide agreed-upon standards with respect to the definition and standardization of alternative investment funds and
their investment strategies. In the mutual fund sphere, it is likely a very good assumption that a Canadian large-
capitalization equity fund invests the vast majority of its assets in large-capitalization equities based in Canada
and listed on Canadian stock exchanges. This makes the performance comparison valid when comparing it to other
mutual funds with the exact same investment strategy.
However, an investor does not have this level of comfort when using performance index data covering the
alternative investment industry. There are no standards or controls over which investment strategy universe or
sub-universe an individual alternative investment manager decides to be included in. For example, say a hedge fund
manager decides to have a fund included in the convertible bond arbitrage sub-universe of hedge fund managers.
Then suppose that over 40% of that particular fund’s assets were invested in merger arbitrage investments during
the performance reporting time period. Should that fund be included in the convertible bond arbitrage sub-
universe, the merger arbitrage sub-universe, both sub-universes or neither sub-universe? Unfortunately, there is
no standard in the alternative investment management industry to help answer this question in an appropriate
manner.

LACK OF INVESTMENT STRATEGY TRANSPARENCY

The lack of transparency of an alternative investment manager’s strategy also affects an investor’s ability to verify
that a specific fund and its manager are being included in the appropriate peer group for performance evaluation
and assessment. Some hedge fund strategies, particularly global macro, have very wide latitude as to what types
of investments and strategies an investment manager can employ over time. This latitude makes performance
comparisons with peers very difficult, if not impossible.

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THE UNIQUE RISKS OF ALTERNATIVE INVESTMENTS

All asset classes have risks associated with them. In the case of most traditional asset classes, these risks are
well understood and measured. However, there are a number of additional unique risks that must be considered
when thinking about investing in alternative asset classes. Some of these risks emanate from the unique return
characteristics of the asset class itself, while other risks arise from the investment management strategies that are
typically used in the management of these alternative asset classes. A number of these risks are discussed below.

LESS REGULATORY OVERSIGHT

As most alternative investments are offered as private placements, they are not required by securities laws to
provide the comprehensive initial and ongoing information that is associated with securities offered through a
prospectus. This lack of transparency can mean that investors in some alternative investment vehicles may not
always know how their money is being invested.
For example, it is possible that an unscrupulous alternative investment manager could be covering up losses by
reporting inflated earnings. This type of fraud might not be identified until it is too late for investors to recover any
of their initial investment. Also, the alternative investment manager may stray from the fund’s stated investment
strategy, thereby engaging in a practice known as style drift. Once again, because of the lack of ongoing reporting
requirements, investors may not find out about this until long after the fact.
To avoid these types of situations, the onus is on investors and their advisors to conduct thorough due diligence on
alternative investment managers and their funds prior to and while investing in them. Due diligence checks should
include a review of the fund’s audited financial statements to support the representation of historical performance
and a detailed review of its offering memorandum. There is more on due diligence later in this chapter.

TRANSPARENCY RISK
Transparency risk refers to the risk incurred by investors’ limited access to information about their alternative
investments, including the fund’s operation, as well as its holdings and performance. As discussed earlier, this
information is not available or presented to investors in a fully transparent manner, as would be the case with
mutual funds. The degree and amount of fund or product transparency is stipulated in the alternative investment’s
offering documents or partnership agreement. Many alternative investment managers do not want information
about their fund’s operation or its holdings leaking into the financial markets and to competing investment
managers. However, depending on the particular fund, this might be very appropriate and certainly in the best
interests of the fund’s investment manager and its investors.

MANAGER AND MARKET RISK

The management of mutual funds has evolved to the point where an investor’s performance expectations are
usually defined by the benchmark a manager is measured against. In other words, the manager’s performance is
measured against a particular index. Alternative investment funds do not seek to produce returns relative to a
particular index, but strive to generate positive returns, regardless of market direction. Therefore, the risk-return
characteristics of the strategies alternative investment managers use, and whether they are focused on hedging
strategies or strategies exposed to significant market risks, become important.
A mutual fund manager’s performance is more likely to reflect the general performance of the markets they are
trading in, whereas an alternative investment manager’s performance largely depends on the manager’s investment
skills and abilities. In light of this, it is more important to clearly understand the manager’s risk and return metrics,
including expected return, expected risk (as measured by the standard deviation), the Sharpe ratio, the overall
percentage of positive months, and so on. These metrics provide a more objective measure of the manager’s
performance than an index that is unrelated to the underlying strategies.

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COMPLEX INVESTMENT STRATEGIES

Many alternative investments involve different and often bigger risks than are normally associated with traditional
investments. Frequently, the assumption of new risks — or even ones associated with traditional investments —
is coupled with leverage in the investment strategy’s execution, thus increasing, sometimes substantially, the
potential for an investor to incur significant losses. Even if alternative investment managers try to mitigate risk, the
investment techniques and strategies they employ may be difficult to understand. As a result, investors may not
fully understand them. Investors should try to understand the investment manager’s strategies and techniques as
much as possible, and ask them questions to ensure they are not participating in an investment strategy they are
uncomfortable with.

LIQUIDITY RISK
In the case of private equity and real estate alternative investments, liquidity risk is very obvious. However, it can
also be a factor in hedge funds that focus on very thinly traded public securities. A lack of liquidity for an extended
period of time can lead to sustained losses for a fund if its manager is unable to trade into or out of particular
securities.

PRODUCT LIQUIDITY CONSTRAINTS

Unlike mutual funds, alternative investment funds are typically not able to liquidate their portfolios on short notice.
Holding less liquid investments often produces some of the excess returns generated by hedge funds. This liquidity
premium is part of the trade-off against traditional investments. In light of this, there are often various forms of
liquidity constraints imposed on hedge fund investors. It is important to note that the liquidity risk discussed in
the previous section refers to the amount of liquidity in the investments themselves, whereas product liquidity
constraints are the terms and conditions under which investors can redeem their investments in an alternative
investment fund or product. Product liquidity constraints are explained in the alternative investment fund’s offering
documents, and are therefore agreed upon by investors at the time of their initial investment.
A lockup refers to the time period when an initial investment cannot be redeemed from an alternative investment
fund or product. Some alternative investment funds require lockups of three years or more. While lockups of
this duration are not common for alternative investment funds that are offered on a continuous basis in Canada,
some alternative investment funds do have initial lockup periods or charge an early redemption fee if the initial
investment is redeemed within the first three months to one year. Once the lockup period is over, the investor is free
to redeem shares on any liquidity date specified in the offering memorandum. Longer-term lockup periods tend to
be more often associated with real estate and private equity funds.
Liquidity dates refer to pre-specified times of the year when investors may be allowed to redeem units in an
alternative investment fund. Some alternative investment funds can be liquidated only on a quarterly or annual
basis. If they wish to redeem their units, investors often need to give alternative investment funds advance notice,
such as 30 days or more before the actual redemption. As is the case with traditional mutual fund managers,
alternative investment fund managers can refuse redemptions if there are unusually poor conditions in the markets
that prevent the orderly liquidation of a fund’s investments.
For an alternative investment manager, the length of the lockup period represents a cushion, which is particularly
useful to a new manager. If the alternative investment fund experiences a sharp drawdown — a sharp reduction in
NAV, which is defined as the peak-to-trough decline in the fund’s NAV — after its launch, the lockup period forces
investors to stay in the fund rather than bail out. An alternative investment fund’s ability to demand a long lockup
period and still raise a significant amount of money depends on its manager’s quality and reputation, as well as the
shrewdness of its marketers.

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LIMITATIONS ON TRANSFERABILITY
Another type of liquidity risk often associated with alternative investments is the difficulty — or outright inability —
for investors to transfer their security interest in an alternative investment fund or product to other parties. Many
types of alternative investment vehicles, such as limited partnerships, generally have clear and limited restrictions
as to the limited partners’ ability to sell or transfer partnership interest to another party. Many of these types of
funds are only seeking investors who will remain in the investment over an extended, and often set, period of time.
This could create liquidity problems in an investor’s own financial affairs, even if the investment in the partnership is
performing well. Many partnership agreements have some limited facility for partners to be able to sell all or part of
their partnership units to other limited partners.

INCOME TAX IMPLICATIONS

The income taxation of alternative investment funds is as varied as the structures used to offer them. Some
alternative investment funds, such as limited partnerships and domestic trusts, are subject to full taxation on an
annual basis. Others offer full tax deferral by using offshore structures to defer tax until disposition. In addition,
some portion of the returns may be taxed as income, while other portions are considered capital gains for tax
purposes.
Investors must assess whether a fund’s investment strategies will primarily generate income or capital gains, or a
combination of the two, and how its investment and trading policies might increase their own tax obligations. Prior
to their initial investment, investors should seek the assistance of tax professionals to clarify the tax implications of
an alternative investment fund or product.

PRICING RISK
Many alternative investment funds hold securities or other types of assets for which it is very difficult to obtain valid
and realistic market prices. In particular, pricing is a risk in real estate funds and private equity funds where certain
assets or properties might trade only once every few years. However, pricing risk can also be a factor in hedge funds
that invest in publicly traded securities, especially if they trade in very illiquid sectors and securities and have, in
relation to the market, large positions in them. In such cases, the prices that are based on market-sourced data
might not be representative of the actual prices that would be realized if most, or all, of the hedge fund manager’s
position had to be sold quickly. These price discrepancies can be very large and depend on the liquidity associated
with the security itself and the overall tone of the market in which the security trades.
Sometimes pricing is left to the hedge fund manager. These situations can result in the hedge fund manager
manipulating the market price, which can lead to overstated values for particular securities and the overall fund’s
NAV. Some alternative investment managers who price their own non-publicly traded securities use proprietary
algorithms. These algorithms are referred to as “black box models”, since only very few individuals who work with
the managers are permitted to have knowledge of the models’ bases and assumptions. Accordingly, these models
have not been reviewed and assessed by industry academics and other participants as to their validity, application
and accuracy. A manager’s use of such models introduces “black box pricing risk” to the securities priced or valued
using them. A number of these models have failed during periods of extreme shifts and high volatility in the capital
markets, when the models’ assumptions were discovered — after the fact — to be severely limited and inaccurate.

SHORT SQUEEZE RISK

Hedge fund managers, in particular, must be very skilled at assessing the difficulty and cost to cover or buy back
the securities they have previously sold short. With less liquid securities, a hedge fund manager might have a lot
of difficulty finding parties who are willing to sell an amount of securities at quoted market prices to enable the
manager to cover a short position. This is known as short squeeze risk, which generally increases during periods of
extreme bullishness in financial markets.

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COUNTERPARTY RISK
This is the risk that the party on the other side of the security trade, often referred to as the counterparty, will be
unable to honour its commitments under the terms of the trade. Counterparty risk arises when the counterparty
slips into financial distress or failure prior to honouring all of its outstanding financial commitments, such as security
transactions. If the counterparty is an investment dealer, the alternative investment manager and fund might end
up in a position where they are not able to complete the sale or purchase transaction that was entered into with the
dealer. Such a scenario can have financial costs for the fund, since the investment manager must try to complete
the sale transaction with another investment dealer at a new and possibly lower market price, or they must try
to purchase the original securities from another dealer at a new and possibly higher market price. In this example,
the investment dealer counterparty was acting as an agent in the purchase or sale transaction, but is nonetheless
responsible for the security transaction’s effective completion.

FINANCING RISK
Many alternative investment managers use borrowed capital or financing in their investment strategy’s execution.
Most hedge fund managers use some degree of leverage when managing their fund. The amount of leverage used is
unique and varies depending on the hedge fund’s strategy and the fund manager’s own strategy. However, one thing
hedge fund managers have in common is that their financing tends to be short term in nature and obtained from
the investment dealers or brokers with which they are trading securities. Hedge fund managers face a real challenge
if investment dealers increase the cost of a hedge fund’s short-term financing or, worse, reduce the amount of
financing available.
The cost and availability of an investment dealer’s short-term financing can change very quickly, because it is
affected by both financial market conditions and the dealer’s own financial situation. Investment dealer–sourced
financing can be amended or called on with as little as one day’s notice to the hedge fund. This type of situation
could have an extremely negative impact on the hedge fund and its value if it forces a liquidation or purchase at
greatly disadvantageous prices.
Though it tends to be lower, financing risk also often arises for real estate and private equity funds, where financing
for a fund’s investments and transactions — if and when required — is carefully matched to the nature of the asset
being financed. This is a prudent financing strategy that can effectively reduce the refinancing risk for an alternative
investment fund or product.

BUSINESS RISK
When it comes to alternative investments, one of the biggest and most overlooked risks is the business risk
associated with the fund or product’s manager. Unlike large, well-capitalized mutual fund organizations, many
alternative investment management firms are often start-up businesses or very small organizations with limited
amounts of capital. A new firm tends to be undercapitalized and the manager tends to be inexperienced at running
this type of business. An alternative investment manager may be a competent investment manager but lack the
skills or abilities to run a business.
Furthermore, most alternative investment funds are often highly dependent on the skills and investment abilities
of the investment manager, who is frequently the general partner if the alternative investment vehicle is structured
as a limited partnership. Investment decisions are often made by relatively few staff — sometimes by only one
individual. For this reason, the inability of one or more of the key personnel to carry out their investment and
business-related duties could have an adverse effect on the investment or partnership. Although business risk can
also play a role in traditional investments, it affects alternative investments differently, because it may prove very
costly or even impossible to exit these types of investments due to liquidity issues, as explained earlier.

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DUE DILIGENCE
Due diligence is a reasonable investigation of a proposed investment and its principals. The goal of due diligence is
to ascertain an investment’s worthiness and appropriateness for particular types of investors. What follows are the
primary objectives and purpose of performing due diligence on an investment fund:
• To properly determine the risk profile of an investment; and
• To address as many of the risks as possible.

When investing in any type of investment fund, whether it involves traditional or alternative investments, the
investor is essentially buying into four main factors:
1. The expertise and capabilities of the investment manager’s principal officers
2. The investment manager’s specific investment strategies, processes and systems
3. The fund’s historic performance
4. The fund’s corporate, tax, regulatory and custodial structure

The proper assessment of these four factors can be quite involved, particularly when performing a due diligence
analysis on an alternative investment fund or product. The unregulated nature of the alternative investment
management industry, and the fact it is essentially comprised of unique investment firms with unique investment
strategies and processes, complicates the process.
The due diligence process is often divided into four steps or stages, as follows:
1. Screening potential investment funds and products
2. Identifying potential investment opportunities through performance reviews and presentations from
investment managers
3. Conducting full due diligence reviews and analysis
4. Continuously monitoring the fund and its investment manager after the investment has been made

A comprehensive due diligence process for investment funds, both traditional and alternative ones, should address
the following eight main areas:
1. Structure of the investment management organization
2. Investment management information (personnel and experience)
3. Fund or product risk analysis
4. Operations and an assessment of operational risks
5. Fund or product structure (or both)
6. Investment performance and attribution analysis
7. Investment manager’s account structure and composition
8. Compensation and fee structure

The limited information provided by most alternative investment funds makes the due diligence process a more
difficult and drawn-out process than with conventional investment funds.
Advisors typically have more access to information about the alternative investment fund industry than clients
do. For example, they can participate in conference calls with alternative investment fund managers, and attend
seminars and conferences featuring presentations by the managers. Most alternative investment managers allow

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advisors to phone them and ask questions about their funds. Advisors should contact alternative investment
fund managers not only before investing in a fund, but also routinely, as part of an ongoing due diligence process,
because alternative investment funds can change over time.

ASSESSING AN ALTERNATIVE INVESTMENT FUND’S RISK PROFILE

Advisors could develop a scoring system to assess an alternative investment fund’s risk profile, which is similar to a
client’s risk profile. The following questions should be addressed when assessing any alternative investment fund’s
risk profile. Please note that this list is not exhaustive; rather, it provides information about the main areas that
should be addressed during a due diligence review.

INVESTMENT MANAGER’S INVESTMENT PROCESS AND STRATEGY

• What is the alternative investment fund’s investment process, philosophy and style?
• Is leverage used and, if so, how much? How is it employed?
• Does the fund use hedging strategies?
• Are derivatives used to hedge or speculate?
• What hedging strategies are used and why?
• What risk controls does the fund have in place?
• Have profits been made evenly across investments/strategies, or by a handful of winning positions?
• Have losses come from a high number of trades, high expenses, a small number of bad trades or positions, or for
other market reasons?
• Does the fund have foreign exchange risk?
• Are there capacity constraints for the fund’s investment strategy?
• At the initiation of a position, does the manager have a maximum loss tolerance and, if so, do they use a stop-
loss rule (a predetermined price below the current market value where a security will automatically be sold)?
• What type of market environment is required for the manager’s investment strategy to work? Is there
something currently happening in the markets that makes this investment strategy more or less attractive?
• What is the worst type of market environment that could negatively affect the manager’s investment or trading
strategy, or both?

FUND DETAILS
• Are audited financial statements available for the fund?
• Are the fund’s historical returns actual returns or simulated returns?
• How long is the fund’s lockup period?
• What is the fund’s liquidity risk?
• How does the fund’s high water mark work (a stipulation that the fund’s value must be greater than its previous
greatest value for the manager to receive a performance fee)?
• What are the fund’s or product’s subscription and redemption policies?

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INVESTORS’ LEGAL AND TAXATION ISSUES

• What are the legal and taxation issues for the fund’s investors?
• Where is the fund domiciled and how is its income treated for tax purposes?
• Is the fund registered with, or subject to regulation by, any securities regulators?
• What is the fund’s legal structure and does it create any risk of personal liability to investors?
• Is the fund structured as a limited partnership or trust?

BUSINESS ISSUES
• Does the current manager have a long-term track record for the fund’s strategies?
• How much capital has the manager personally invested in the fund?
• Is the investment management company profitable at its current level of assets under management?
• How stable and well-financed is the investment management company?

HYPOTHETICAL QUESTIONS
• How do changes in market factors, such as prices, volatilities and correlations, affect the fund?
• How do declines in the creditworthiness of the entities in which the fund invests affect the fund?
• How does a decline in market liquidity affect the value of the fund’s investments?

CURRENT TRENDS AND DEVELOPMENTS IN ALTERNATIVE INVESTING

Financial markets are always changing and evolving, and the alternative investment sector of the global investment
management industry is no different. Some of the major events and trends are worth discussing.

INCREASED GOVERNMENT REGULATION

Due to a number of factors, not the least of which is the failure of a few high-profile hedge funds, there has been
an increasing call from many individuals and politicians for more regulatory oversight of the hedge fund industry
in particular, especially in the U.S. As mentioned earlier, the hedge fund and alternative investment industry is the
least regulated of all major investment sectors, including mutual funds and securities underwriting.

INSTITUTIONALIZATION
The alternative investment industry in general, and the hedge fund industry in particular, are quickly becoming
institutionalized — that is, as institutional investors become bigger players in the area of alternative investing, they
are able to change industry practices and standards somewhat over time. Institutionalization might turn out to be
the key factor that propels the alternative investment industry to a higher level of investor interest.
Many large institutional investors that are investing in alternative investments have, over time, invested in the
people and technology they felt they needed to allow them to participate in the alternative investment industry
on a basis they deemed prudent. Working alone or in concert, these large institutional investors are standardizing
a number of the unique processes and procedures involved in the creation, investment and management of various
types of alternative investments. Most investment managers must operate their businesses and funds at the level of
proficiency and professionalism mandated by the large institutional investors if they hope to ever get an investment
allocation from them.

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Most large institutional investors are regulated and must conduct their business and investing affairs according
to the regulatory standards emanating from, say, banking and insurance industry regulators, and from their own
industry best practices. These standards are directly and indirectly working their way into the investment practices
and standards of these large institutional investors. It seems this trend is sure to accelerate over the near term.

CONTINUED INNOVATION
One thing is for sure — the alternative investment industry can never be accused of lacking innovation. In reality, it
is likely the most innovative sector of the global financial and capital markets. New alternative investment products
appear overnight and often catch even the most seasoned industry veterans in awe.
In some regards, the alternative investment management industry is still in its infancy, having only really been
recognized as a serious contender in the global investment arena over the past few decades. However, despite all
of the well-publicized hedge fund industry disasters and the increasing volatility of financial markets in general, the
alternative investment industry continues to grow rapidly.

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SUMMARY
After completing this chapter, you should be able to:
1. List the primary characteristics and attributes of alternative investments.
Alternative investments cover a wide range of investment opportunities. The major categories include hedge
funds, private equity, real estate and commodities.
Hedge funds are lightly regulated pools of capital whose managers have great flexibility in their investment
strategies. Hedge fund strategies include relative value strategies, event-driven strategies and directional
strategies.
« Relative value strategies include equity market neutral, convertible arbitrage and fixed income arbitrage.
« Event-driven strategies include merger or risk arbitrage, distressed securities and high-yield bonds.
« Directional strategies include long/short equity, global macro, emerging markets and dedicated short bias.
A fund of hedge funds (FoHF) is a portfolio of hedge funds overseen by a manager who determines which
hedge funds to invest in and how much to invest in each.
Commodities are another class of alternative investments. Investments in commodities can be made in two
primary ways:
« Directly: By buying and selling commodities
« Indirectly: Through commodity derivatives — that is, futures, forwards or swaps
Managed futures funds: They invest in listed financial and commodity futures markets and currency markets
around the world.
Private equity: Denotes equity investments that are not actively traded on public markets. Private equity
investments include leveraged buyouts, mezzanine capital, venture capital and infrastructure investments.
Real estate: From the point of view of the financial markets and portfolio management industry, real estate
is seen as an alternative to traditional investments, such as stocks and bonds.

2. Explain the main factors for the continued and growing interest in alternative investments.
Alternative investments offer a number of potential benefits that are neither characteristic of nor present in
traditional investments. The following summarizes these potential benefits:
« They offer improved portfolio diversification
« They can realize profit in any economic environment
« They reduce portfolio volatility
« They enhance long-term total risk-adjusted return
« Investors gain access to investment managers (and investment strategies) that are not generally available
to the public
« They preserve capital in volatile markets
« They provide access to global markets
« They align interest with investors through variable performance fees
« They align the interests of investors with those of investment managers

3. Describe some of the major issues and challenges an alternative investment manager must deal with and why
they must be dealt with properly.
Asset allocation process: At issue are which alternative investments to include in the policy portfolio and in
what proportions.

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Security pricing and valuation: There is no independent and accurate source of security pricing for the vast
majority of investments made by alternative investment managers.
Short sales: Some start-up hedge fund investment managers and their administrative staff have limited
experience in executing and settling security short sale transactions.
Accounting for leverage: The investment management firm must always be aware of the amount of leverage
in each of its funds. This information should ideally be available on a real-time basis, since the amount of
leverage in many hedge funds changes throughout the day as trading occurs.

4. Describe how the asset allocation process is used and modified when alternative investments are included in a
portfolio’s asset mix.
Alternative investments do not conform well to many of the key assumptions underlying standard mean-
variance optimization. Most alternative asset classes tend to be skewed and characterized by significant
kurtosis.
A modification to models can be made to include the skewness and kurtosis measures for each asset class
under consideration.

5. Identify some of the main problems and issues that arise when doing performance attribution for alternative
investments.
Lack of suitable performance benchmarks
Lack of mandate definition and standardization
Lack of investment strategy transparency

6. List and describe some of the unique key risks of alternative investments and why they must be considered
prior to investing in them.
Less regulatory oversight: Most alternative investments are not required by securities laws to provide
comprehensive and ongoing information.
Transparency risk: Refers to the risk incurred by investors’ limited access to information about their
alternative investments, including the fund’s operation, as well as its holdings and performance.
Manager and market risk: An alternative investment manager’s performance largely depends on their
investment skills and abilities.
Complex investment strategies: They can lead to an increased potential for significant losses.
Liquidity risk: It can lead to losses if the manager is unable to trade into or out of particular securities.
Product liquidity constraints: They are the terms and conditions under which investors can redeem their
investments in an alternative investment fund or product.
Limitations on transferability: The difficulty — or outright inability — for investors to transfer their security
interest in an alternative investment fund or product to other parties.
Income tax implications: The income taxation of alternative investment funds is as varied as the structures
used to offer them.
Pricing risk: Many alternative investment funds hold securities or other types of assets for which it is very
difficult to obtain valid and realistic market prices.
Short squeeze risk: Hedge fund managers, in particular, must be very skilled at assessing the difficulty and
cost to cover or buy back the securities they have previously sold short.
Counterparty risk: This is the risk that the party on the other side of the security trade, often referred to as
the counterparty, will be unable to honour its commitments under the terms of the trade.

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Financing risk: One thing hedge fund managers have in common is that their financing tends to be short
term in nature and obtained from the investment dealers or brokers with which they are trading securities.
Hedge fund managers face a real challenge if investment dealers increase the cost of a hedge fund’s short-
term financing or, worse, reduce the amount of financing available.
Business risk: Many alternative investment management firms are often start-up businesses or very small
organizations with limited amounts of capital. Most alternative investment funds are often highly dependent
on the skills and investment abilities of the investment manager.

7. Describe the due diligence process when thinking about investing in an alternative investment.
The primary objectives and purpose of an investment fund due diligence is to properly determine the risk
profile of an investment and address as many of the risks as possible.
The due diligence process has four steps or stages: screening potential investment funds and products,
identifying potential investment opportunities through performance reviews and presentations from
investment managers, conducting a full due diligence review and analysis, and continuously monitoring the
fund and its investment manager.
A comprehensive due diligence process involves eight main areas of enquiry: structure of the investment
management organization, investment management information (personnel and experience), fund or
product risk analysis, operations and an assessment of operational risks, fund or product structure (or both),
investment performance and attribution analysis, investment manager’s account structure and composition,
compensation and fee structure.

8. Discuss the primary trends and developments in the alternative investment management industry and their
potential impact on its development.
Increased government regulation: An increasing call from many individuals for more regulatory oversight of
the alternative investment industry, particularly the hedge fund industry.
Institutionalization: Increased investment in alternative investments by institutional investors.
Continued innovation: New alternative investment products appear overnight.

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 Client Portfolio Reporting and
Performance Attribution 12

CONTENT AREAS

Client Portfolio Reporting

Portfolio Management Reports

Performance Attribution

LEARNING OBJECTIVES

1 | Describe the Global Investment Performance Standards (GIPS) and why most institutional
investment management firms are in compliance with them.

2 | Describe a typical portfolio management report and highlight the type of information included in it.

3 | Explain why both book and market prices are included in portfolio management reports.

4 | Explain why there are often discrepancies between a portfolio manager’s report and a custodian’s
report regarding a fund.

5 | Know the difference between performance reporting and attribution.

6 | Apply performance attribution analysis to evaluate a portfolio manager’s skills.

7 | Explain style drift.

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KEY TERMS

Key terms are defined in the Glossary and appear in bold text in the chapter.

clearing (of trades) returns-based style analysis

Global Investment Performance Standards settlement (of trades)

(GIPS)
style analysis
holdings-based style analysis
style drift
market prices
trade-matching elements
performance attribution

portfolio management report

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INTRODUCTION
This chapter briefly examines the Global Investment Performance Standards (GIPS). It also examines what is
contained in a basic portfolio management report. Because the actual settlement process is vulnerable to errors,
we explain how a portfolio management report is constructed. Lastly, we touch upon aspects of performance
attribution, how the analysis is performed and, finally, what it provides in terms of evaluating a portfolio manager’s
skill.

CLIENT PORTFOLIO REPORTING

GLOBAL INVESTMENT PERFORMANCE STANDARDS

The investment management industry is becoming more global in scope. However, performance measurement and
reporting standards have varied considerably from country to country. Some countries have established guidelines,
while others have few standards. These varied practices limit the comparability of performance results between
firms from different countries and have hindered those wishing to increase global business. The Global Investment
Performance Standards (GIPS) present investment performance fairly and ethically to current and potential
clients.
The GIPS standards, which have evolved over the last two decades, are the product of the CFA Institute’s Investment
Performance Council. Since they are standards, not laws, firms do not necessarily have to be compliant with GIPS
standards. In fact, adopting the GIPS standards is voluntary. However, there are benefits for institutional investment
management firms and their clients to comply with the GIPS standards, as follows:
• Standardized performance presentation guidelines assure investors that performance information is complete
and fairly presented. The guidelines also give investors a common yardstick with which to compare investment
management firms, even if the firms are located in different countries with different laws and protocols.
• By knowing that an investment management firm complies with the GIPS standards, prospective and existing
clients will have a greater degree of confidence in the firm’s performance numbers. Performance standards that
are accepted across all countries enable firms to measure and present their performance so that clients can
easily compare performance among various managers. In fact, firms that choose not to comply with the GIPS
standards may be at a competitive disadvantage. Some institutional investors will not consider an investment
manager whose firm is not compliant with the GIPS standards.

To date, 37 countries, including Canada and the U.S., have adopted the GIPS standards.

KEY ASPECTS OF THE GIPS STANDARDS

There are many GIPS standards on performance and presentation that a firm is required to follow to be compliant,
and other standards that a firm is only recommended to abide by. This chapter will touch upon only the most salient
requirements. Some of the key aspects of the GIPS standards that will be briefly discussed in the following sections
are as follows:
• Information about a firm
• Composite requirements
• Data used to determine performance calculations
• Calculation methodologies
• Presentation and reporting guidelines
• Information about a firm’s responsibilities

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A FIRM
To begin the compliance process with the GIPS standards, a firm must specifically define the legal entity that
encompasses it. A firm is a distinct business entity that is presented to clients as a group that performs investment
management, whether it is a division, a department or a unit. In defining a firm, it is important to avoid presenting
its performance on too narrow a basis. At the same time, it is important not to define a firm’s performance so
broadly that it includes other parts whose returns could materially misrepresent the performance of the firm’s
investment process.
In addition, for periods beginning January 1, 2011, a firm’s total assets must be the aggregate of the fair value of all
of its discretionary and nondiscretionary assets under management (AUM) within the defined firm. A firm must
also include the performance of assets assigned to a sub-advisor, provided the firm has control over the selection of
the sub-advisor. Finally, changes in a firm’s organization may not be used as a reason to alter historical composite
results. Composites are the firm’s discretionary, fee-paying portfolios amalgamated along a particular investment
strategy, such as emerging markets, small-capitalization funds and so on. This rule exists to prevent firms from
reorganizing and thereby dropping unfavourable return data from their presentation.

COMPOSITES
In order to disclose their performance clearly with respect to specific strategies, firms must include all actual, fee-
paying, discretionary portfolios in at least one composite. Non-fee-paying discretionary portfolios, such as a model
portfolio, may be included in a composite as long as there are appropriate disclosures. Non-discretionary portfolios
are not permitted in a firm’s composite because the firm needs to distinguish its skill on its discretionary strategies.
Furthermore, if any portfolios were discontinued, they must be included in the historical returns of their appropriate
composites, up until the last full measurement period that the portfolio was in existence. Also, portfolios cannot be
freely switched between composites, unless a firm has documented proof of changes in client guidelines or changes
in the composite’s definition.

DATA
A firm must maintain and capture all of the data it deems necessary to support and perform the required
performance calculations and presentations. Valuations must be based on fair values.
Portfolios are to be valued at a minimum frequency, depending on their inception date. For portfolios established
prior to January 1, 2001, valuations must be performed at least quarterly. For portfolios established on or after
January 1, 2001, valuations must be performed at least monthly. For periods beginning January 1, 2010, firms must
value portfolios on the date of all large external cash flows. Lastly, firms must use trade date accounting — data on
the date of trade — for periods beginning January 1, 2005.

CALCULATION METHODOLOGIES
The GIPS standards are quite specific regarding the types of calculation methodologies permitted in composites. For
instance, total return, which includes realized and unrealized gains and losses plus income, must be used. Dollar-
weighted returns are not permitted with external cash flows. Instead, time-weighted returns are used. Periodic
returns must be geometrically linked. External cash flows should be treated in a manner consistent with the policies
associated with the specific composite. The returns from cash and cash equivalents in portfolios must be included in
the total return calculations.

PRESENTATION AND REPORTING

To provide investors with a sufficient idea of a firm’s investment skills, the GIPS standards require that each
composite show at least five years of performance data. If a firm or the composite has been in existence for less
than five years, the data should start from the inception date of the firm or composite.

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After presenting five years of performance, a firm has to provide additional performance of up to 10 years.
Therefore, if the firm has been doing business for seven years, its composites would have, at a minimum, five- and
seven-year performance records. On the firm’s 10th anniversary and every year thereafter, the firm would present
five- and 10-year performance records.
Each year of a composite’s performance record must show annual returns. Each composite must disclose the
number of underlying portfolios and the amount of assets. If a composite contains five portfolios or less, a firm does
not have to report the number. Also, each composite must disclose either the percentage of a firm’s total assets
represented by the composite, or the amount of total firm assets at the end of each annual period.

A FIRM’S RESPONSIBILITIES
A firm cannot be selective with regard to who they want to be able to see composite performance. It must make
every reasonable effort to provide a compliant presentation to any prospective client. This information should
include a description of the composites, a list of the discontinued composites and a full list of the composites that
are available. A firm that is compliant with GIPS standards that jointly markets its services with another firm that is
non-compliant with GIPS standards must ensure that only it claims to be compliant.

PORTFOLIO MANAGEMENT REPORTS

A portfolio management report is a document of record that an institutional client refers to for information on a
firm’s holdings and performance. Investment managers prepare these reports for institutional investors that invest
in their pooled funds, segregated funds and limited partnerships. Portfolio management reports can provide data on
either a trade date or settlement date basis.
A portfolio management report focuses on a fund’s particulars. On a monthly basis, detailed portfolio accounting
information is included for each security holding. This information could cover facts such as:
• The issuer’s name
• The number of shares held
• The market value per share, either as the closing price on valuation day, the last traded price, the bid price on
valuation day or an average of the bid and ask prices
• The total market value for each issuer based on the per share price
• The maturity date, call date, retraction date and coupon (for bonds)
• The market value of each issuer as a percentage of the total portfolio’s market value
• The total book value of each holding — the cost of purchase, including commissions — on a per share and issuer
basis
• The unrealized gain or loss of each holding — the market value less the book value
• The annual yield, dividend or coupon interest, and payments in kind

Issuer information is grouped by industry sector. Holdings are further grouped by asset class — for example, short-
term securities, Canadian equities, foreign/U.S. equities and fixed income. These reports have the look and feel
of a fund’s financial statements. Portfolio management reports pertain to an entire fund, with no reference to its
unitholders.
On a quarterly or yearly basis, portfolio management reports tend to have much more portfolio management
information and details on a portfolio’s trading activities and performance for the reporting time period. The reports
typically include a detailed explanation of the portfolio manager’s investment strategy, performance attribution,

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outlook for the market and major industry sectors, plus any planned changes in investment strategy. They also
include details such as the number of security transactions (portfolio turnover) and a statement of the portfolio’s
realized gains and losses. Some of the features of quarterly and yearly portfolio management reports are as follows:
• The changes in the portfolio’s sector or industry holdings on a quarter-over-quarter basis.
• A list of the portfolio’s five to 10 largest security holdings at quarter end by portfolio weighting and by the
change in portfolio weighting versus the previous quarter end.
• The portfolio’s total rate of return on both a time-weighted and dollar-weighted basis.
• The portfolio’s total rate of return divided between trading gains and income.
• The relative ranking of the portfolio’s performance against the appropriate institutional investment manager
peer survey, and also against any appropriate market performance benchmarks — for example, the S&P 500
Index and TSX Index.
• The portfolio’s rate of return statistics.
• The detailed performance attribution report, which shows the major sources of under and overperformance for
the quarter — that is, cash holdings, sector and security over or underweighting versus the appropriate capital
market index weighting.
• The current portfolio’s value at risk.
• A report, which is typically a half to a full page in length, that discusses the major events that affected the
economy and capital markets during the quarter.
• An analysis of how the investment strategy performed versus the market and its competition.
• A summary of the portfolio manager’s outlook for the economy and the capital markets for the next one or two
quarters.
• A summary of how the portfolio is positioned to capitalize on the portfolio manager’s capital market outlook.

Portfolio management reports are not typically circulated among a firm’s mutual fund unitholders, and often form
the basis for the quarterly performance stewardship reports and presentations that institutional portfolio managers
present internally to the mutual fund manager. These reports often form the basis for the regular quarterly
presentations by portfolio managers to the mutual fund’s sponsor or manager.
Mutual fund unitholders receive a report that has less extensive information about each of the portfolio’s particular
holdings. For example, compared to a portfolio management report, a unitholder report, which is published on a
monthly or quarterly basis, does not include as much detailed information about each security holding’s position.
The unitholder report only includes a list of the top 10 to 20 security holdings by weight and their respective
proportionate weightings in the portfolio.
This report is often posted on the mutual fund manager’s website and is therefore accessible to all current investors
and the public. However, mutual fund security regulations require that the annual reports to unitholders contain
the portfolio’s detailed security holdings and other information that is included in a typical portfolio management
report.

BOOK VERSUS MARKET PRICES

In portfolio management reports, security values are available at both book (cost) and market prices. For strictly
economic purposes, such as risk management and portfolio performance, market price–based reporting is fine.
However, because tax liabilities are based on a security’s costs, both formats are used in portfolio management
reports.

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MARKET PRICES
For risk management and performance measurement, market prices are more useful than historical costs. However,
sometimes the notion of market prices can be interpreted in different ways.
For instance, stock market prices are usually taken as the last trade of the day. This makes sense, because they
represent an actual trade. On the other hand, the last trade of the day may have occurred earlier in the trading session.
But, for some securities, the last trade may have occurred several days ago. So what would reflect the actual market
price? In certain cases, the actual bid price may be a better proxy than the price of the last transaction. For over-the-
counter securities, average bid prices or the average midpoint between bid and ask prices can be used.
For rarely traded securities, some institutions will use a marked-to-model approach for reporting purposes. Once a
pricing model is accepted as being a good proxy to value a security, it can be used for reporting. The main problem is
that the assumptions that existed when the model was established may not hold when it comes time to report.

TAX IMPLICATIONS
Each time a security is sold, a tax treatment is done. Provided their income is taxable, the owner has to determine if
the sale created a capital gain or loss. The security’s cost is its book value. This book value is determined by dividing
the total cost of buying all identical securities, including transaction costs, by the number of securities the investor
owns.
For foreign investments held by Canadians, the historical cost of a position needs to be measured in Canadian
dollars for tax purposes. Therefore, even for accounts in U.S. dollars, the investment manager still needs to know
what the exchange rate was each time a transaction took place or a dividend was received, as these events have to
be recorded in Canadian dollars.
For non-taxable accounts, one might assume that it is not necessary to keep track of the historical cost because
no taxes have to be paid on the accounts. However, the historical cost does need to be tracked, as performance
measurement rules still require that realized gains or losses be distinguished from unrealized ones.

COMPARING PORTFOLIO MANAGER AND CUSTODIAN REPORTS

When an institutional portfolio management firm makes trades, it will make note of them in its internal records and
update the portfolio as of the trade date. However, the clearing and settlement of trades is a lengthy and time-
consuming process. Clearing is the process of confirming and matching security trade details, and settlement is
the moment of irrevocable exchange of cash and securities.
A custodian, who is a firm’s official record-keeper, records information about a portfolio on the settlement date,
which is usually no more than two business days after the trade date. This time is needed to clear and settle the
trades. The process is prone to errors, because there are several parties other than the buyer and seller who need to
complete the process. As a result, there could be discrepancies between the manager’s and the custodian’s records.
To understand how errors creep into the process, a detailed explanation of the clearing and settlement process is
necessary.

THE SETTLEMENT PROCESS

A typical institutional trade involves at least three parties: an investment manager, acting on behalf of underlying
client accounts, who decides which securities to buy or sell and how the assets are allocated among the client
accounts; a dealer, who executes the trades; and a custodian, who holds the institutional investor’s assets. After the
institutional investor places an order with and receives a trade execution notice from a dealer, they must provide
the dealer and custodian with certain details to facilitate the settlement of the trade. These trade and account

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details are known as trade-matching elements. For an institutional equity trade to clear, 26 different elements
must be confirmed. These elements can be grouped into two categories: security identification, and order and trade
information.

Exhibit 12.1 | Trade-Matching Elements – Security Identification, and Order and Trade Information

Security Identification

1. Standard numeric identifier 3. Issuer 5. Market identifier (e.g., ticker)

2. Currency 4. Type, class and series

Order and Trade Information

6. Dealer ID 14. Message date and time 22. Custodian

7. Account ID 15. Trade transaction type 23. Payment indicator
8. Account type 16. Commission 24. Investment manager portfolio
9. Buy or sell indicator 17. Broker settlement location and account ID

10. Order status 18. Block reference 25. Quantity allocated

11. Order type 19. Net amount 26. Settlement conditions

12. Unit price/face amount 20. Settlement type

13. Quantity of securities 21. Allocation sender reference

In turn, the dealer must issue to the custodian a customer trade confirmation with the required trade information.
Once all of the trading details have been confirmed, the next step is matching, in which the relevant parties match
and verify the elements shown in Exhibit 12.1. The matching process is such that the custodian who holds the
institutional investor’s assets must confirm the trade so it can be ready for the clearing and settlement process
through the clearing agency’s facilities. Once the matching has taken place and the custodian has confirmed the
trade, the following steps are taken:
1. The manager advises the dealer and custodian(s) how the traded securities are to be allocated among the
manager’s underlying institutional client accounts.
2. The dealer reports and confirms the trade details to the manager and clearing agency. The categories of trade
details that must be confirmed for matching, clearing and settlement purposes are similar to the information
the institutional manager requires.
3. The custodian(s) of the institutional investor’s assets verifies the trade details and settlement instructions
against the available securities or funds held for the investor. Once both sides agree on the trade details, the
manager instructs the custodian(s) to release the funds or securities, or both, to the dealer through the clearing
agency’s facilities.

Therefore, the matching process requires that both sides of the trade agree to the terms, and that the custodian(s)
verifies the availability of the required funds and securities.

CURRENT PROBLEMS WITH INSTITUTIONAL TRADE PROCESSING

Institutional trades are much more complicated than retail trades, because they involve larger amounts of
money and securities, as well as additional parties and processing steps between an order’s initiation and its final
settlement. There are three aspects of the clearing and settlement process that sometimes cause errors and delays,
as follows:

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Inadequate Technology Inadequate technology is the leading cause of errors and delays relating to institutional
trade processing. There is a lack of automated processing, real-time functionality and
standard interfaces between trade parties and the custodian(s). Many of the messages
sent by investment managers and dealers are transmitted by telephone or fax. Moreover,
the recipient of these messages must manually re-key the information, which increases
the likelihood of error, which in turn requires manual intervention to repair. Thus, the
entire process of clearing and settling a trade is delayed. Most messages between the
parties of an institutional trade are largely processed in batches at the end of the day,
rather than in real time or near real time.
Currently, many of the parties use different communication protocols, which have
different message standards. Consequently, messages have to be processed manually,
resulting in a greater chance of error and a processing delay. Also, the means of
communication between many institutional parties are ineffective. For example, an
investment manager does not have online access to the Canadian Depository for
Securities Limited (CDS), the agency that settles and clears all security trades in Canada,
to monitor the status of their trade, nor do they have the ability to prevent a failed trade
by correcting the settlement details online. The investment manager must rely on the
dealer or custodian, who has online access to CDS, to notify the manager of the failed
trade verbally or by fax to correct the details.

Timing of activities The second cause of errors and delays in institutional trade processing relates to the
timing of different steps in the trade process when notices of execution or allocation are
missing or late. If an investment manager provides allocation instructions to a dealer
relatively late, the trade will likely fail to settle. This ends up delaying the entire process,
because the custodian will not process the trade until they receive instructions from the
investment manager.

Data Integrity and Incorrect data is the leading cause of most failed trades. In order for an institutional trade
Accounting Issues to be processed and settled by T+2 (two business days after the trade), all trade details
or data elements must be agreed to by all relevant parties involved in the post-trade
processing. For one reason or another, an investment manager may not provide certain
data elements, making settlement virtually impossible, unless the dealer or custodian
commits the necessary time to contact the investment manager to retrieve the missing
data elements.

EXAMPLES
Examples of Discrepancies
Because of the inefficiencies in the clearing and settlement process, discrepancies can occur between a custodian’s
records and an investment manager’s records. The investment manager or client should perform a reconciliation
of these reports. Some of the most frequently encountered discrepancies, and the steps managers should take to
prevent or address them, are as follows:
• The manager should ensure that all executed trades are being accounted for by the custodian at the correct
price. Given that the settlement date is two days later than the trade date, the manager has to make sure
sufficient cash will be available to settle all trades.

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EXAMPLES
Examples of Discrepancies – cont'd
• In the portfolio manager’s account, when the stock goes ex-dividend, an entry should be made to take into
account the dividend to be received. The performance measurement should include the dividend, even
though it is not yet available to investors. When the dividend is eventually received, the account dividend to
be received is decreased and the cash is increased.
• A portfolio manager has to make sure that the dividend the client should receive (stocks being held on the
cum-dividend date) is indeed received on time.
• The prices of the stocks being split are adjusted more rapidly than the quantity of the stocks the custodian
is holding. Whether it is a split or a stock dividend, the market price adjusts the first ex-dividend or ex-
split trading day, while the number of shares accounted for by the custodian can take a few days to adjust.
Therefore, there could be a discrepancy in the market value by using the custodian’s report versus the
portfolio manager’s report.
• When the firm issues rights to its existing shareholders, the portfolio manager has to ensure the custodian
receives them. In addition, the manager has to decide what to do — exercise, sell or let the rights expire.
• In a large portfolio, stock issuers may be acquired by or merged with other firms. Payment could be cash,
securities or a mix of both. Some deals offer choices to shareholders. The portfolio manager has to make sure
the appropriate choice they made for their clients is what is eventually reported in the custodial records.
• When foreign securities are held, the market value is calculated using their foreign exchange price that is
translated back into Canadian dollars using an appropriate exchange rate. This exchange rate may differ
between the custodian and portfolio manager. Typically, the difference is that one is using the closing
exchange rate, while the other is using the noon exchange rate. Using the closing exchange rate makes sense,
because the security’s closing price should be matched with the exchange rate of the same time. On the
other hand, some argue that the closing exchange rate is not based on large trading, unlike the noon one, and
therefore may not reflect actual market forces.

PERFORMANCE ATTRIBUTION
Portfolio performance attribution, which is the evaluation of a manager’s performance by attributing a portfolio’s
success or failure to specific decisions, is an important component of the investment process for the following
reasons:
• It ensures a portfolio’s investment objectives are being satisfied.
• It is an important statistic used to monitor a portfolio manager’s performance.
• It is used to calculate the value added of the investment strategy.

Performance attribution is not the same as portfolio reporting. In creating a portfolio, the portfolio manager must
decide which asset classes to include, and how much weight to assign to each asset class in the managed portfolio.
Furthermore, the manager needs to decide the sub-composition of each asset class — that is, which particular
stocks or bonds to pick within those broad asset classes. As such, there are many decisions that go into a portfolio’s
composition. Portfolio reporting gives a sense of how a portfolio has performed at an overall level, but it does not
indicate which of the manager’s decisions were particularly beneficial, and which ones could have been improved.
Performance attribution attempts to answer these questions.
Performance attribution takes a managed portfolio’s overall return and breaks it down into various decision
components. It is a tool used to evaluate a portfolio manager’s investment talent and skills. The overriding objective
of the attribution process is to separate out the skills component from the luck component — that is, was the

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managed portfolio’s return earned due to competent investment decisions the manager made, or was it simply
earned due to chance?

AN EXAMPLE OF PERFORMANCE ATTRIBUTION ANALYSIS

Performance attribution analysis can be done in multiple ways, with the evaluation of various portfolio manager
decisions. For example, some performance attribution analysis separates out a portfolio’s overall return into
industry selection, security choice, and up and down markets, while others may include style allocation and market
timing.
The example provided in this section will look at the following two components of an overall portfolio’s return:
1. Asset allocation
2. Security selection

The first component refers to the broad allocation of investable wealth into fixed income, equity and cash. The second
component involves deciding which individual securities to include in each asset class. In this example, in order to
understand why the managed portfolio behaved the way it did, it will be compared to an appropriate benchmark.
That is, the investment management decisions affecting this portfolio will be compared to those of the benchmark
portfolio — also called the bogey portfolio — in order to evaluate the efficacy of the portfolio manager’s choices.
Portfolio performance attribution involves four steps, as follows:
• Step 1: Calculating the managed portfolio’s return.
• Step 2: Calculating the benchmark portfolio’s return.
• Step 3: Calculating the managed portfolio’s excess return.
• Step 4: Explaining the difference in returns based on asset/component allocation and security selection.

The example that follows uses just two components to break down the overall return; however, once the attribution
analysis process is understood, it can be extended to include other decision components, such as industry selection,
style and so on.
Consider a managed portfolio that comprises equity, bonds and cash. The investment allocated to each of these
three broad categories is 75%, 12% and 13%, respectively. Assume that the appropriate benchmark portfolio has a
composition of 65% equity, 25% bonds and 10% cash.
The exercise breaks down the managed portfolio’s excess return into two components — asset allocation and
security selection — then compares these components to the benchmark portfolio. The example computes how
much of the managed portfolio’s excess return arose due to the manager’s broad allocation across asset classes, and
how much came about because he was accurately able to select the individual securities within each asset class.

STEP 1: CALCULATE THE MANAGED PORTFOLIO’S RETURN

Table 12.1 illustrates the managed portfolio’s calculated return.

Table 12.1 | Managed Portfolio’s Return

Asset Class Weight (%) Return of Asset Class (%)

Equity 75 6.94
Bonds 12 1.43
Cash 13 0.42

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Based on these values, the managed portfolio’s return is 5.4312%, which is calculated as follows: (0.75 × 0.0694) +
(0.12 × 0.0143) + (0.13 × 0.0042) = 0.054312.

STEP 2: CALCULATE THE BENCHMARK PORTFOLIO’S RETURN

For comparison purposes, the benchmark portfolio’s return is calculated in Table 12.2 below.

Table 12.2 | Benchmark Portfolio’s Return

Asset Class Weight (%) Return of Asset Class (%)

Equity 65 5.42
Bonds 25 1.20
Cash 10 0.42

The overall return is calculated in the same way as the managed portfolio. In this case, the benchmark portfolio’s
return is 3.8650%, which is calculated as follows: (0.65 × 0.0542) + (0.25 × 0.0120) + (0.10 × 0.0042) = 0.03865.

STEP 3: CALCULATE THE MANAGED PORTFOLIO’S EXCESS RETURN

In order to accurately compare the managed portfolio against the benchmark portfolio, the excess return must first
be calculated, as follows:
Excess return = Managed portfolio’s return – Benchmark portfolio’s return
= 5.4312% – 3.8650%
= 1.5662%

STEP 4: EXPLAIN THE DIFFERENCE IN RETURNS

Now that we know the managed portfolio’s excess return is 1.5662%, we need to attempt to break down this
number by the portfolio manager’s asset allocation and security selection decisions. Table 12.3 represents the asset
allocation contribution to the managed portfolio’s excess return.

Table 12.3 | Asset Allocation Contribution to the Managed Portfolio’s Excess Return

Managed Benchmark Contribution of

Portfolio Portfolio Excess Weight Asset Class Asset Class to
Weights (%) Weights (%) (%) Return (%) Performance (%)
(1) (2) (3) = (1) – (2) (4) (5) = (3) × (4)

Equity 75 65 10 5.42 0.5420

Bonds 12 25 –13 1.20 –0.1560
Cash 13 10 3 0.42 0.0126
Total Portfolio 100 0.3986

In Table 12.3, column 3 calculates the difference between the asset allocation weights assigned in the managed
portfolio to those of the benchmark portfolio. Column 4 lists the market return for each asset class and column
5 calculates the contribution of each asset allocation to overall performance. Thus, 0.3986% of the managed
portfolio’s excess return can be explained by the manager’s asset allocation decision.
From Step 3, recall that the managed portfolio earned an excess return of 1.5662% over the benchmark portfolio.
Of this excess return, 0.3986% can be attributed to the portfolio manager’s prudent asset allocation decisions.

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Thus, the remaining 1.1676% must be due to security selection. However, the portfolio manager made two security
selection decisions, namely, which securities to include in the managed portfolio’s equity component and which
bonds to include in its fixed income component. The next step breaks down the 1.1676% into security selection for
both equities and bonds, as illustrated in Table 12.4.

Table 12.4 | Security Selection Contribution to the Managed Portfolio’s Excess Return

Managed Asset Class Asset Class Contribution

Portfolio Return – Managed Return – Bogey Excess Return to Performance
Weights (%) Portfolio (%) (%) (%) (%)
(1) (2) (3) (4) = (2) – (3) (5) = (1) × (4)
Equity 75 6.94 5.42 1.52 1.1400
Bonds 12 1.43 1.20 0.23 0.0276
Total 1.1676

In Table 12.4, column 1 specifies the weights allocated to each asset class in the managed portfolio. Columns 2 and
3 give the returns for each asset class for the managed portfolio and the benchmark portfolio, respectively. For each
asset class, column 4 calculates the managed portfolio’s excess return as compared to the benchmark portfolio. The
contribution of asset allocation is the weighted average of the excess returns for each asset class, with the weights
being the percentage of total investable wealth allocated to each asset class in the managed portfolio. Note that
the total contribution of security selection decisions across both asset classes is 1.1676%. When this figure is added
to the 0.3986% attributable to the portfolio manager’s asset allocation decisions, the excess return of the managed
portfolio over that of the benchmark portfolio is 1.5662%.
To summarize, the managed portfolio earned 5.4312%, while the benchmark portfolio earned 3.8650%. Of
the managed portfolio’s excess return of 1.5662%, 0.3986% can be allocated to the portfolio manager’s asset
allocation decisions and 1.1676% can be allocated to their security selection decisions. Of the excess return of
1.1676% return due to security selection decisions, 1.14% was due to the portfolio manager’s equity picks, while
0.0276% was due to their bonds picks.
The above performance attribution analysis reveals that the portfolio manager seems to have security selection
skills — at least during the time frame in question. The manager’s security selection had a greater effect on equities
than on bonds. Making this differentiation in skills — security selection versus asset selection, stock selection versus
bond selection — is important in determining whether a manager has the skills they claim to have. For instance,
using the example above, a client who invested with the manager would be reassured if they had claimed to be a
stock picker, where there was a value-add of 1.14%. The client would be less assured if the manager was specifically
hired to select bonds or rotate among asset classes, where the value-add was only 0.0276% and 0.3986%,
respectively).

SECTOR ATTRIBUTION
Performance attribution can be done along any dimension through which a portfolio manager can add active
returns. The previous section highlighted performance attribution along asset timing choices. This section will
highlight attribution along sector choices in both an equity and a bond portfolio.

SECTOR ATTRIBUTION OF AN EQUITY PORTFOLIO

Consider an equity manager whose portfolio returned 12.55% over the previous calendar year. On a relative basis,
the manager did well, because their benchmark index returned 11.27% over the same period. What dimension of
active skills did this manager display during the year? Did they demonstrate sector selection skills or stock-picking

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skills? It is not apparent by looking at the raw overall returns. Both the managed portfolio and the benchmark index
need to be broken down into their respective sector weights and returns, which is shown in Table 12.5 below.

Table 12.5 | Sector Weights of the Managed Portfolio and Benchmark Index

Portfolio Weight Portfolio Sector Index Weight Index Sector

(%) Return (%) (%) Return (%)
Energy 33 15.2 29 23.8
Materials 13 20.7 9 12.3
Industrials 3 4 7 1.7
Consumer Discretionary 5 7.8 6 2.2
Consumer Staples 1 3.9 5 6.8
Health Care 1 –9.5 3 –5.1
Financials 36 11.4 32 8.1
Information Technology 0 0 2 –5.6
Telecommunication Services 2 –1.4 4 1.7
Utilities 6 5.2 3 9.3
Total Weighted Portfolio/
Index Return 12.549 11.274

The process of finding allocation and selection effects is similar to that of the previous section. The results are
illustrated in basis points in Table 12.6 below.

Table 12.6 | Asset Allocation and Security Selection Returns in Basis Points

Portfolio Portfolio Index Index Allocation Selection

Sector Sector Sector Sector Effect Effect
Weight (%) Return (%) Weight (%) Return (%) (Basis Points) (Basis Points)

Energy 33 15.2 29 23.8 95.2 –283.8

Materials 13 20.7 9 12.3 49.2 109.2

Industrials 3 4 7 1.7 –6.8 6.9

Consumer Discretionary 5 7.8 6 2.2 –2.2 28

Consumer Staples 1 3.9 5 6.8 –27.2 –2.9

Health Care 1 –9.5 3 –5.1 10.2 –4.4

Financials 36 11.4 32 8.1 32.4 118.8

Information Technology 0 0 2 –5.6 11.2 0

Telecommunication Services 2 –1.4 4 1.7 –3.4 –6.2

Utilities 6 5.2 3 9.3 27.9 –24.6

Total Weighted Portfolio/

Index Return 12.549 11.274 186.50 –59

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The attribution analysis reveals that the portfolio manager demonstrated skills during the calendar year when
selecting industry sectors by adding 186.5 basis points to the portfolio over the benchmark, but detracted from the
portfolio’s overall return through poor stock selection by losing 59 basis points. The sum of allocation and selection
effects, which is 127.5 basis points, is the total value added to the portfolio — 12.549% less 11.274%.
In general, the manager did not have poor stock selection skills. Poor stock selection seemed to be concentrated
in only two sectors: Energy and Utilities. Strong stock selection skills were evident in the Materials and Financial
sectors. The manager did not have good uniform sector selection skills, as some value was lost in their allocations to
the Consumer Staples, Consumer Discretionary and Industrials sectors.

SECTOR ATTRIBUTION OF A BOND PORTFOLIO

The mathematics of a bond portfolio’s attribution is not as straightforward a process as an equity portfolio’s
attribution. It is far more rigorous — and beyond the scope of this course — and requires the use of specialized
software. However, it is still useful to know what the attribution factors are, as defined below:

Income Effect For bonds with no embedded options and for mortgage-backed securities (MBS), this
effect is equal to the coupon interest. For other securities, such as a collateralized
mortgage obligation (CMO), the income effect incorporates amortization toward par.

Pay-Down Effect For MBS bonds, CMOs and asset-backed securities backed by home equity loans, this
effect accounts for principal prepayments or amortization at par.

Amortization/ This is the percentage change in a bond’s price as it moves closer to maturity and rolls
Roll Effect (moves) along the slope of the yield curve. The amortization component is based on the
change in amortized price from the beginning to the end of the period.

Duration Effect This reflects the impact of the change in the general level of interest rates. It is defined
as the percentage change in a security’s price that would occur if the yield curve shifted
in a parallel fashion equal to the change in the 10-year Treasury price.

Convexity Effect This reflects the impact of embedded options on returns from callable securities, MBS or
other structured securities that may be in a portfolio.

Curve Effect This reflects the return due to the actual change in the underlying yield curve’s shape
in excess of the hypothetical parallel shift described in the duration effect above. This
category captures the change in the yield curve’s shape over the period.

Sector/Quality Effect This is the percentage change in a bond’s price attributable to the widening or tightening
of option-adjusted spreads (OAS) that was observed for a bond’s peer group. OAS
measures the yield spread that is not directly attributable to a bond’s characteristics.
A larger OAS means a greater return for greater risks. A peer group is the combination
of the primary sector, quality rating, effective duration and currency; for example, the
Industrials sector, a single A quality rating, an effective duration of 2.0–3.0 and currency
in U.S. dollars. The effect observes the excess return over Treasuries realized by each peer
group.

Security Selection This is the portion of the actual price return that is not explained by the term structure
(duration, roll and yield curve) and sector/quality effects. This effect isolates the return
due to a change in the bond’s OAS that is greater or less than the change in the average
OAS of the bond’s peer group.

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Residual Factor This is the portion of the reported return that is not entirely explained by the other
effects. The most common source is pricing noise, where the portfolio’s actual reported
return is computed using prices from a source that is different than the prices used in the
attribution analysis.

PERFORMANCE ATTRIBUTION STYLES

Performance attribution styles refer to the dimensions of risk and return that exist in the market. Styles are
systematic approaches to investing that are shared by large groups of investors. Style analysis matters because
different styles are rewarded differently by the market.
Style analysis is the study of style drift in a fund’s holdings or returns over time. Style drift, which is given
important consideration in performance analysis for several reasons, occurs when a manager’s portfolio strays
from a specific investment management style. A small-capitalization manager who invests in large-capitalization
stocks during a period when small-capitalization stocks are underperforming cannot be viewed as a skillful small-
capitalization manager. Generally, the relative performance of a portfolio with a significant style bias will depend
largely on whether or not the specific style has performed well. The style differences may dominate the portfolio’s
relative returns even if the manager has strong stock selection skills. The more style drift that exists in a manager’s
investment approach, the more difficult it becomes to separate the manager’s skills from sheer coincidence.
Furthermore, style drift makes it more difficult to ascertain a fund’s appropriate risk level. Without a grasp of the
risk, it is impossible to set an ideal asset allocation ratio.
However, style analysis is not easy, as some portfolios represent a blend of styles, thus style classification becomes
a matter of subjective judgement. It is not always easy to classify a managed portfolio into one particular style.
Furthermore, portfolio compositions and manager styles may change over time. This could be true of either
the managed portfolio or the benchmark portfolio. As a result, comparing the returns of these portfolios over a
measurement period may not be entirely accurate. Finally, style analysis may be difficult to apply in an international
context because of the varying definitions of style categories across countries and markets. However, there are
generally two methodologies used to do a style analysis: returns and holdings.
The foundation for returns-based style analysis was developed by Nobel Prize–winning economist William Sharpe
in a 1988 article entitled “Determining a Fund’s Effective Asset Mix.”1 Sharpe suggests that a fund’s investment
style may be determined by comparing the fund’s returns — usually 36 to 60 months of data — to the returns of a
number of selected passive style indexes. These style indexes represent different investment styles or asset classes,
such as large-capitalization value, large-capitalization growth, small-capitalization growth, small-capitalization
value, government bonds and cash-equivalent asset classes.
Sharpe considered investment styles to be broken down into 12 broad categories, as follows:2
1. Treasury Bills
2. Intermediate bonds
3. Long-term bonds
4. Corporate bonds
5. Mortgage-related securities
6. Large-capitalization value stocks
7. Large-capitalization growth stocks

1
William F. Sharpe, “Determining a Fund’s Effective Asset Mix,” Investment Management Review (December 1988): 59–69.
2
William F. Sharpe, “Asset Allocation Management Style and Performance Measurement,” Journal of Portfolio Management (Winter 1992):
7–19.

© CANADIAN SECURITIES INSTITUTE (2019)

 CHAPTER 12 | CLIENT PORTFOLIO REPORTING AND PERFORMANCE ATTRIBUTION 12 • 17

8. Mid-capitalization stocks
9. Small-capitalization stocks
10. Non-U.S. bonds
11. European stocks
12. Japanese stocks

A quadratic minimization procedure is applied to minimize the difference in monthly return performance between a
fund’s performance and a set of portfolio weights for the style indexes under consideration. Returns-based analysis
then constructs a set of portfolio weights for the style indexes such that the composite index’s return maximizes the
correlation to the fund’s return.

EXAMPLE
Quadratic minimization may indicate that a small-capitalization value fund’s composite benchmark could be
17% cash, 17% large-capitalization value, 11% small-capitalization growth and merely 55% small-capitalization
value.

Each of the 12 investment style categories represents a strategy that can be replicated using a low-cost index fund.
Thus, the benchmark not only provides a standard to which style composition can be compared, but also a passive
strategy that provides a return stream with which returns from style drift can be judged.
Holdings-based style analysis examines each stock in a portfolio and maps it to a style at a specific point in time,
in effect creating a history in the form of snapshots. Style can be determined by looking at capitalization, price-to-
book ratios, price-to-earnings ratios or dividend yield. Once a large enough history has been collected, a profile of
the fund’s average style can be developed and used as the custom benchmark.
There are merits and drawbacks to each of these methods. The trade-off is between ease of use and accuracy.
Returns-based analysis is the easiest to use, as it only requires monthly returns. Holdings-based analysis requires
detailed portfolio data that is neither easy nor inexpensive to obtain. In addition, the holdings-based method has
no way to account for any derivatives that may be in a portfolio. However, holdings-based analysis is the most
transparent and accurate method, because every stock can be tracked and correctly categorized by style.
Results from returns-based analysis may be inaccurate if the style indexes used in the quadratic minimization have
overlapping membership, meaning they are highly correlated. Also, for portfolios with less than two years of history,
holdings-based analysis is the only methodology to use. There are commercially available software packages that
can conduct either type of analysis.

ATTRIBUTING FOR STYLE DRIFT

Attributing for style drift in a portfolio is markedly different from attributing for sector or security selection. The
analyst must account for style drift over time, rather than look at a snapshot of a moment in time. For example,
to track an equity manager’s style drift, an analyst must plot the portfolio’s large-capitalization value, large-
capitalization growth, small-capitalization growth and small-capitalization value proportions according to the
results from returns- or holdings-based analysis and compare them over several years or quarters.
A small-capitalization growth manager with 80% small-capitalization growth, 5% small-capitalization value and
15% large-capitalization growth could be suspected of style drift if the proportions over a year became 60%, 10%
and 30%, respectively. This style drift might be the result of small-capitalization growth migration into the large-
capitalization growth category, or it could be a conscious effort on the manager’s part to increase the portfolio’s
overall returns with a large-capitalization growth allotment. To find a definitive answer, a client or advisor would
need to question the manager on their current investment practices.

© CANADIAN SECURITIES INSTITUTE (2019)

12 • 18 PORTFOLIO MANAGEMENT TECHNIQUES

SUMMARY
After completing this chapter, you should be able to:
1. Describe the Global Investment Performance Standards (GIPS) and why most institutional investment
management firms are in compliance with them.
GIPS standards are an effort to present investment performance fairly and ethically to current and potential
clients.
Compliance with GIPS standards is not mandatory, but non-compliance can put a firm at a competitive
disadvantage.

2. Describe a typical portfolio management report and highlight the type of information included in it.
Portfolio management reports provide information on a firm’s holdings and performance to an institutional
investment client.
On a monthly basis, a portfolio management report contains detailed information for each security holding.
On a quarterly or yearly basis, the report contains additional information, as well as details on a portfolio’s
trading activities and performance for the reporting period.

3. Explain why both book and market prices are included in portfolio management reports.
Security values in portfolio management reports are available at both book (cost) and market prices. Market
prices are more useful in risk management and performance measurement, but book prices are required for
tax purposes.

4. Explain why there are often discrepancies between a portfolio manager’s report and a custodian’s report
regarding a fund.
The clearing and settlement of trades is prone to errors because there are several parties other than the
buyer and seller who need to complete the process.
There are three areas in the clearing and settlement process that sometimes cause errors and delays:
« Inadequate technology
« Timing of activities
« Data integrity and accounting issues

5. Know the difference between performance reporting and attribution.

Portfolio reporting gives a sense of how a portfolio has performed at an overall level, but it does not indicate
which of the portfolio manager’s decisions were particularly beneficial, and which ones could have been
improved.
Performance attribution takes a managed portfolio’s overall return and breaks it down into various decision
components. It is a tool used to evaluate a portfolio manager’s investment talent and skills.

6. Apply performance attribution analysis to evaluate a portfolio manager’s skills.

There are four steps in a portfolio performance attribution analysis:
« Step 1: Calculate the managed portfolio’s return.
« Step 2: Calculate the benchmark portfolio’s return.
« Step 3: Calculate the managed portfolio’s excess return.
« Step 4: Explain the difference in returns based on asset allocation and security selection.

© CANADIAN SECURITIES INSTITUTE (2019)

 CHAPTER 12 | CLIENT PORTFOLIO REPORTING AND PERFORMANCE ATTRIBUTION 12 • 19

7. Explain style drift.

Style drift occurs when a manager’s portfolio strays from a specific investment management style.
The more style drift that exists in a manager’s investment approach, the more difficult it becomes to
separate the manager’s skills from sheer coincidence.
Style drift makes it more difficult to ascertain a fund’s appropriate risk level.

© CANADIAN SECURITIES INSTITUTE (2019)

Glossary
alternative investments basis risk
A
Investments that have different The risk that the basis — the price
performance characteristics from difference between an asset and
absolute advantage traditional assets, such as stocks its derivative — will not behave as
A barrier to entry that helps deter and bonds; that are rarely traded in expected over the life of a hedge.
companies from entering an industry. the public capital markets; that are
relatively illiquid; that are relatively bearer form
accredited investor uncommon in investment portfolios; Investments that were in bearer form
Institutional investors that have that have a relatively limited meant that the security certificate
net assets of at least $5 million; or investment history; and that require being exchanged was negotiable
individual investors that (alone or with unconventional investment skills on and payable to the bearer, which is
a spouse) have financial assets with an the part of the manager. referring to a time when transactions
aggregate realizable value exceeding were settled by the exchange of
$1 million or net income before taxes asset mix committee cheques rather than by electronic
exceeding $200,000 (or $300,000, A committee, usually composed of means.
if combined with a spouse) in each the chief investment officer and heads
of the two most recent years, and a of various asset class groups, which beneficiary
reasonable expectation of exceeding establishes the target asset mix for the In a fiduciary relationship, the
that same income in the current year. various balanced fund portfolios a firm beneficiary is the person to whom a
manages. fiduciary owes a fiduciary duty.
active bond management
A bond management style that tries asset-backed securities (ABS) beta
to profit from interest rate risk by A type of bond whose cash flows are The systematic risk or the extent to
predicting the direction or magnitude supported by the cash flows from a which an investment moves with the
of interest rate changes. specified pool of discrete assets. overall market.

active portfolio management audit board of trustees

A portfolio management style that Verifying that all of the firm’s functions An independent committee
recognizes that securities markets are are conducting their affairs and established to oversee a pension plan’s
not efficient and adjusts a portfolio activities in conformance with its operation.
through sector rotation, timing or established operational procedures
momentum strategies, or by the — basically, that the rules established bond swap
search for undervalued stocks. by the firm’s compliance and legal
Normally involves the purchase of one
functions are being followed.
bond and the simultaneous sale of
advisors
another related or unrelated bond.
Those people or companies that advise
clients on which investments to hold in
bottom-up approach
their portfolios. B An investing style that focuses on the
merits of an individual security. It can
alpha backtesting take the form of either a value-oriented
The measure of a manager’s skills in The retrospective analysis of a or a growth-oriented approach.
adding value by taking active risk. potential investment product.
box trade
barbell portfolio Involves the simultaneous execution of
In a barbell portfolio, bonds are a pair of related fixed income security
initially purchased at both ends of the swaps.
term structure — that is, the portfolio
consists of 30-year and one-year
bonds.

© CANADIAN SECURITIES INSTITUTE (2019)

G•2 PORTFOLIO MANAGEMENT TECHNIQUES

buy-and-hold strategy client services contingent immunization

Purchasing bonds with available funds Services offered by an investment Where a manager is willing to risk
and holding each bond to its maturity, management firm that provide current some of the portfolio’s value in the
thereby avoiding the interest rate risk investors with timely and relevant practice of active management, but at
on an early sale. information about their portfolios a certain lower level wants to protect
under management. themselves against further losses. It is
often used as a compromise between
closet indexing passive and active bond management.
C The tendency of active managers to
build a portfolio that is close enough corporate governance
Canadian Securities Administrators to a performance benchmark so that The set of processes, customs, policies,
(CSA) the portfolio neither underperforms laws and institutions affecting the way
The CSA, which is a working group of nor outperforms the benchmark by an investment management firm is
regulators from each provincial and very much. directed, administered or controlled.
territorial regulator, is charged with
forging uniformity in regulation where code of ethics covered call option
possible. An integral part of ensuring that a A call that is sold with the underlying
discretionary portfolio manager’s asset already owned in the portfolio.
cash collateralized debt obligation fiduciary duty is performed and that all
A specific type of asset-backed security clients and investors are treated fairly credit default swap
in which the originator sells the and appropriately. A type of credit derivative where an
collateral (assets) for cash to a special exchange of two cash flows occurs: a
purpose vehicle (SPV). The collateral collateralized debt obligation (CDO) fee payment made by the buyer and
can consist of mortgage-backed A security that repackages a collection a conditional payment made by the
securities, corporate bonds, other ABSs of underlying assets and sells multiple seller, made only if a credit event is
or CDOs. classes (tranches) of the asset pool’s triggered.
interest to investors. A CDO can take a
cash-secured put option cash or synthetic form. credit derivatives
Where the fund has adequate cash to Financial instruments that derive their
purchase the shares if the put option is collective investment vehicles value from an underlying credit asset
exercised. See pooled investment vehicles. or pool of credit assets, such as bonds
or mortgages, and are designed to
cellular sampling commodities transfer and manage credit risk.
A strategy used to recreate a fixed An alternative investment class that
income index portfolio where each offers diversification benefits when currency cross-hedge
of a bond’s three dimensions — combined with a traditional portfolio A transaction in which the mutual
maturity, coupon and credit risk — is containing equities and bonds. fund substitutes its exposure to one
applied to the fund’s total capital and currency risk for exposure to risk from
representatives of each cell are bought commodity pools another currency, as long as neither
in proportion to the total index. Funds that buy and sell commodity is the currency in which the mutual
futures contracts. fund’s net asset value is determined.
chief compliance officer (CCO)
The person who is responsible for compliance
designing and implementing a Ensuring the firm is operating in such
supervision system that will provide a way that it is abiding by the rules D
the firm’s board of directors with and regulations set by the securities
reasonable assurance that compliance regulators, the terms set out in the dealers
standards are being met. firm’s investment management Individuals or companies that actually
agreements with investors and its own trade securities.
chief investment officer established best practices.
The person within an investment deferred sales charges (DSCs)
management firm who has overall Alternative sales commission
responsibility for the firm’s portfolio arrangements where investors can pay
management activities. the sales commission on a deferred
basis over time.
clearing (of trades)
The process of confirming and
matching security trade details.

© CANADIAN SECURITIES INSTITUTE (2019)

 GLOSSARY G•3

defined benefit (DB) plan endowment funds

F
A pension plan where entitlements are Portfolios that are managed to
typically calculated on the basis of the produce income for a beneficiary
employee’s salary profile and tenure organization. fairness policy
of employment. These entitlements A policy that all investment
represent the sponsor’s liabilities. enhanced active equity investing management firms should have
An active portfolio management outlining the way employees will deal
defined contribution (DC) plan technique where the manager with clients in matters of making
A pension plan where the beneficiary overweights the securities that and providing investment analysis,
is typically provided with a menu of are expected to outperform the recommendations or trade services.
investment choices, including mutual benchmark and underweights the The policy ensures that all clients are
funds, among which to allocate regular securities that are expected to treated fairly by a firm’s employees.
contributions. The investment risk is underperform, using short selling if
borne entirely by the beneficiary. necessary. fiduciary
In a fiduciary relationship, the person
delta enhanced indexing in whom trust has been placed.
The price sensitivity of an option to An indexing technique that results in
changes in the underlying asset’s price. portfolios that are designed to provide fiduciary duty
index-like performance with some The duty of a person in a position of
derivatives excess return net of costs. trust to act solely in the beneficiary’s
A financial contract whose value is interest.
derived from, or depends on, some ethical dilemma
other asset’s value. Exists when two or more of the financial intermediaries
possible choices pit different values The various companies and
directional strategy against each other. organizations that connect and move
A hedge fund strategy that bets capital between suppliers and users of
on anticipated movements in the ethical principles capital.
market prices of equity securities, Help guide behaviour in situations
debt securities, foreign currencies and where no regulation exists or applies. financial intermediation
commodities. The movement of funds from suppliers
ethics of capital to users of capital.
due diligence A set of consistent values that guide
The reasonable investigation of individual behaviour. Financial Transactions and Reports
a proposed investment and its Analysis Centre of Canada
principals with the goal of ascertaining event-driven strategy (FINTRAC)
the investment’s worthiness and A hedge fund strategy that seeks to A federal agency created to gather
appropriateness for particular types of profit from unique events such as financial information under the
investors. mergers, acquisitions, stock splits and Proceeds of Crime (Money Laundering)
buybacks. and Terrorist Financing Act.

execution slippage foreign-denominated bonds

E Occurs when the execution of a Bonds issued by domestic or foreign
transaction causes subsequent prices corporations or governments offering
efficient frontier to worsen. diversification from interest rate and
currency risk.
A set of optimal portfolios that match
a client’s expected returns with their exempt investors
forward rate agreements (FRAs)
tolerance for risk. Investors who do not require a firm to
sell them securities via a prospectus. Over-the-counter contracts for
end values hedging interest rates.
Represents the ends toward which exempt market dealer
fund accounting
a person strives and influences A dealer who trades or advises in
how a person acts today to achieve the exempt market, such as private The proper accounting of the fund’s
tomorrow’s goals. placements. asset values.

© CANADIAN SECURITIES INSTITUTE (2019)

G•4 PORTFOLIO MANAGEMENT TECHNIQUES

fund of hedge funds (FoHF) head of fixed income index tracking

A portfolio of hedge funds overseen The person within an investment A passive investment strategy where
by a manager who determines which management firm who has overall the manager constructs a subset of the
hedge funds to invest in and how much responsibility for the portfolio benchmark that faithfully mimics the
to invest in each. management of all of the fixed income index.
and money market securities the firm
fundamental indexing manages. institutional investor
A methodology where each stock’s Any non-retail investor; also known as
index weighting is determined by four hedge funds financial intermediaries, they include
fundamental measures, thus diluting Lightly regulated pools of capital pension plans, mutual funds, insurance
weighting errors and erasing the link whose managers have great flexibility companies, endowments, charitable
between portfolio weight and over or in their investment strategies. foundations, family trusts/estates and
undervaluation. corporate treasuries.
hedge ratio
The relative number of derivatives interest rate futures
contracts per underlying asset Contracts used by banks, corporations
G necessary to insure against portfolio and individuals to hedge interest rate
value changes. risk for future payments.
general partner
Under a limited partnership, the hedged portfolio interest rate risk
institutional investment manager. A portfolio with no exposure to a The variation in bond values due to
specific risk. changes in market yields.
Global Investment Performance
Standards (GIPS) high closing interest rate swaps
Standards that attempt to present An illegal activity where a portfolio Agreements made between two
investment performance from firms of manager enters a higher bid price parties to exchange interest payments
different countries fairly and ethically for a security at closing to artificially on loans for the same amount, with
to current and potential clients. GIPS increase the net asset value of the fund each guaranteeing to pay the other’s
standards are the product of the CFA to which the security belongs. interest for a stated period.
Institute’s Investment Performance
Council, and although not mandatory, holdings-based style analysis investment committee
most investment management firms An analysis of a manager’s style that A committee populated by a subset
are in compliance with them. examines each stock in the portfolio of individuals who serve on an
and maps it to a style at a specific investment management firm’s
go/no-go decision point in time, in effect creating a board of directors that focuses on the
A decision made by the new product history in the form of snapshots. investment management aspects of a
development committee on whether fund’s operations.
or not to proceed any further with the horizon analysis
development of a particular fund or A technique used by analysts to react investment consultants
product. to financial forecasts, where the See pension consultants.
analyst chooses a horizon over which
growth-oriented approach the rate change is expected to evolve, investment dealer
A bottom-up approach to investing and at the end of which a new yield A registration category for an
that focuses on the individual stock, curve is predicted. investment management firm that
specifically on earnings. allows appropriately registered staff
to engage in the sale and distribution
of all types of securities to all types of
I investors.
H
immunization investment-grade credit quality
head of equities A means of protecting a bond portfolio rating
The person within an investment from interest rate risk. When a fixed income security’s issuer
management firm who has overall has at least a BBB credit quality rating
responsibility for the portfolio index funds from at least one of the popular fixed
management of all of the equities the A fund that uses a passive portfolio income credit-rating agencies.
firm manages. construction technique in order to
track a target portfolio’s performance.

© CANADIAN SECURITIES INSTITUTE (2019)

 GLOSSARY G•5

investment management agreement lockup market timing

The contract that governs the The time period when initial Buying or selling global securities after
relationship between an institutional investments cannot be redeemed from global markets have closed — but still
investment manager (the “Advisor”) an alternative investment fund or remain open in North America because
and its institutional investor client product. of time zone differences — to take
(the “Client”). advantage of information that will
affect the securities when the markets
investment policy statement reopen the next day.
A statement developed by the M
investment committee for a fund’s means values
investment program that outlines the Macaulay duration The actions taken in the present to
investment aspects of the fund. The weighted average maturity of achieve a future goal.
a bond where the weights are the
relative discounted cash flows in each micro-capitalization stocks
period. Companies that tend to have a market
K capitalization between $50 million and
Macaulay duration formula $300 million.
Know Your Client (KYC) rule A formula devised by Frederick
An industry best practice stipulating Macaulay in 1938 to deal with the minimum investment exemption
that an investment professional should valuation and time pattern of duration Allows the sale of securities without
give appropriate cautionary advice to on bond: a prospectus to investors who make
and perform appropriate action for a n´k
a prescribed minimum investment.
CFt 1
client based on the client’s investment
objectives and needs.
D= å(t k ) ´ (1 + ( y k ))
t =1
t
´
P
National Instrument 45-106 sets
this minimum at $150,000 across all
jurisdictions in Canada.

managed futures fund modern portfolio theory (MPT)

A fund that invests in listed financial
L A theory developed by Harry
and commodity futures markets and Markowitz contending that a
currency markets around the world. portfolio’s diversification across
laddered portfolio
different asset classes with low or
In a laddered portfolio, bonds are management expense ratio (MER) negative correlation characteristics will
initially purchased with each maturity The amount charged to a fund by the minimize risk.
up to 30 years in equal proportions. fund manager before any returns are
paid out to investors. The MER includes mortgage-backed securities (MBS)
late trading the fund manager’s compensation A portfolio of mortgages assembled
An illegal activity where a mutual fund and other expenses associated with and sold in tranches to increase
company allows a trader to enter an operating the fund. mortgage capital for lenders and offer
order, either to purchase or sell, after
secure higher-yielding medium-term
the established cut-off time. management styles investments that are comparable to
The term used to describe an equity government bonds.
leverage portfolio manager’s investment
The use of borrowed money to extend strategy, which generally falls into two
a fund’s buying power. categories: active or passive.
N
limited partnership (LP) market depth
A common form of business The number of shares available at the National Instruments
organization with one or more general bid price and offer price.
partners who manage the business and A series of regulations developed by
assume legal debts and obligations, the Canadian Securities Administrators
market price (CSA) that are applicable across the
and one or more limited partners who The price that a security will fetch on
are liable only to the extent of their country and serve to harmonize rules
open bidding in the market. Depending and regulations in each jurisdiction.
investment. on the type of security, market prices
can be interpreted in different ways. net asset value (NAV)
liquidity date
Pre-specified times of the year when The market value of the fund’s units or
investors may be allowed to redeem shares on a particular date.
units in an alternative investment fund.

© CANADIAN SECURITIES INSTITUTE (2019)

G•6 PORTFOLIO MANAGEMENT TECHNIQUES

new product development pooled fund

committee
P
An open-ended trust in which investors
A committee put together to vet and contribute funds that are then invested
assess new investment fund or product passive bond management or managed by the institutional
opportunities for the investment A bond management style where investment manager.
management firm. no attempt is made to predict the
direction or magnitude of interest pooled investment vehicles
National Instrument (NI) 81-102 rates, thereby minimizing the effects of Portfolios in which investors place
This NI applies to mutual funds in interest rate risk on a bond portfolio. their money to achieve diversification
Canada and outlines the permitted at lower costs. Some examples are
derivative activities that these funds passive portfolio management mutual funds, hedge funds and private
can undertake. A portfolio management style that investment partnerships.
is consistent with the view that
National Instrument (NI) 81-104 securities markets are efficient — that portable alpha
This NI permits a broader use of is, at all times, securities prices reflect The process of using derivatives or
derivatives by funds that fall into the all relevant information concerning short selling to separate the alpha
definition of commodity pools. expected return and risk. and beta return decisions and to apply
the alpha to portfolios of other asset
non-exempt investors peer investment manager classes.
performance surveys
Small individual retail investors.
Non-exempt refers to the fact that Surveys that are produced by a number portfolio accounting information
investment dealers must sell securities of the larger pension consulting firms Information provided to an
to these investors via a prospectus that and contain sufficient information institutional investor in the portfolio
discloses the fund’s full information, to evaluate the effectiveness and management report that includes
including its background and essential competitiveness of an individual firm’s detailed portfolio holdings, a report on
data about its securities. investment process. all security transactions and an income
report.
pension consultants
People who advise institutional asset portfolio management information
O holders on the choice of external Information provided to an
investment managers. They are also institutional investor in an investment
known as investment consultants. management firm’s quarterly report
offering memorandum exemption
An exemption that waives the to clients that includes return data,
performance attribution holdings data, attribution analysis and
requirement for the security or fund to
Evaluating an investment manager’s market commentary.
be distributed with a prospectus.
performance by attributing the
portfolio’s success or failure to specific portfolio management report
Office of the Superintendent of decisions the manager made.
Financial Institutions (OSFI) The document of record that an
An independent agency of the institutional client refers to for
performance benchmark information on a firm’s holdings and
Government of Canada that
A benchmark against which a new performance.
supervises, monitors and regulates the
investment product will be measured
investment industry.
to explain the fund’s performance. portfolio manager
Ontario Securities Commission An individual, or a team of individuals,
Personal Information Protection and who advises clients on investments
(OSC)
Electronic Documents Act (PIPEDA) appropriate to the clients’ individual
An example of a Canadian securities
A federal law that regulates how circumstances and investment
regulator. The OSC’s mandate, as set
businesses, including investment objectives. The portfolio manager is
by the Government of Ontario, is “to
management firms, handle and secure also responsible for making the day-to-
provide protection to investors from
personal and private data. day investment management decisions
unfair, improper or fraudulent practices
and to foster fair and efficient capital affecting the portfolios for which they
plan sponsor are responsible.
markets and confidence in capital
markets.” In the case of a private pension plan,
the employer offering the pension plan
to its employees.

© CANADIAN SECURITIES INSTITUTE (2019)

 GLOSSARY G•7

portfolio turnover prudent man rule returns-based style analysis

A way to measure the degree or Mandates acting as a thoughtful and An analysis of a manager’s style
amount of active management, careful person would, given a particular developed by William Sharpe. It is
specifically trading activity. It is set of circumstances. performed by comparing the fund’s
calculated by dividing the annual returns — usually 36 to 60 months of
market value of securities trades by the data — to the returns of a number of
market value of the portfolio. selected passive style indexes.
R
pre-operational audit risk budgeting
An audit of all systems and processes rate anticipation swap A process that limits the deviations of
before the launch of a new investment A portfolio management technique a portfolio’s return from a benchmark.
fund to ensure that all operational where the bond portfolio manager It is the most common technique used
aspects associated with the sale decides to position the portfolio with to create an enhanced index portfolio.
and management of the new fund a longer or shorter duration based on
are functioning properly at industry market information. road shows
standards. Meetings in which a fund manager’s
real estate senior and regional sales and
pre-trade compliance testing marketing staff and a new fund’s
An alternative investment that tends
A process to ensure that all security to take two forms: private and public. investment manager make
trades are compliant with all security With the private form, investments presentations to the distributors’ sales
regulations pertaining to both capital are made in real, tangible assets that staff.
market conduct and the particular usually generate steady cash flow
fund, as well as all of the investment from rental income. Real estate takes
guidelines and restrictions that are a public form when it is securitized
agreed upon with the investors prior to — that is, when a pool of real estate S
the execution of the trade. assets is resold to investors as shares.
sale of options
prime brokerage structures real return bonds Selling options to take advantage of
Structures that allow managers to Bonds promising to pay interest based current or desired portfolio holdings
establish a stock loan account with a on inflation levels. and to earn additional income.
broker.
recovery rate sector rotation
private equity
The amount of value/funds eventually The attempt by an active portfolio
Equity investments not actively realized by creditors as a percentage of manager to pick the best sectors.
traded on public markets; classified as the bond’s face or default amount.
alternative investments.
securitization
relative value strategy The process of turning relatively illiquid
pro forma financial projection
A hedge fund strategy that attempts assets into tradable securities.
Financial projections prepared for to profit by exploiting inefficiencies or
a new fund that include three key arbitrage opportunities in the pricing of seed capital
inputs or assumptions: assets under related stocks, bonds or derivatives.
management (revenue), fees charged The capital invested in a new mutual
to investors (revenue), and all fees and fund at the point in time when it is
replicating an index created.
expenses to be charged to the fund.
A passive investment strategy where
the manager selects an appropriate segregated account
project management committee
index to replicate in a fund, holding An investment account that is owned
A committee that is responsible each stock within the fund’s portfolio
for all of the steps and activities by an institutional investor and
in exact proportion to its weighting managed by a third-party portfolio
required to bring a new investment within the index.
fund or product to market after it has manager.
been approved by the new product
repo transaction self-regulatory organizations (SROs)
development committee.
Essentially a sale and repurchase Organizations that have been given
agreement where a broker/dealer sells regulatory supervision by various
provincial and territorial securities
a fixed income security to a third party provincial and territorial securities
commissions
at an agreed upon price today and commissions by way of monitoring the
The governing securities regulators simultaneously agrees to buy back the
in Canada that are charged with activities of their member firms.
same security from the third party at a
enforcing and helping to frame the set price on a future date.
various securities acts of the provinces.

© CANADIAN SECURITIES INSTITUTE (2019)

G•8 PORTFOLIO MANAGEMENT TECHNIQUES

separation of duties principle sub-advisor trade matching elements

A principle that is incorporated into A person or entity that the firm The details that an institutional
a firm’s organizational structure to managing an investment fund will hire investor must provide to a dealer
minimize the potential for employee because the sub-advisor has expertise or custodian in order to facilitate
self-dealing via collusion with another that is deemed appropriate and the settlement of a trade. There are
individual in the firm. beneficial to the fund. 26 different elements that must be
confirmed for an institutional equity
settlement (of trades) synthetic collateralized debt trade to clear.
The moment of irrevocable exchange obligation
of cash and securities. The credit derivative variant of the traders
cash collateralized debt obligation Those employees who execute trades
soft dollar arrangement (CDO), where the originator (the bank) within an investment management
An arrangement where an investment retains ownership of the underlying firm.
firm purchases services via commission assets and buys protection from the
dollars rather than via an invoice for special purpose vehicle (SPV) using a trading philosophy
the goods or services. credit default swap, thus swapping the The role that active security trading
credit risk over to the SPV. plays in executing a particular fund’s
special purpose vehicle (SPV) investment management strategy.
A legal entity that is set up by a loan’s
originator, typically as a trust. It is tranches
the legal owner of the loans and is T Layers of ownership within an ABS.
separate from the originator. Each layer has a different level of
target asset mix credit risk and hence a different level
standards of conduct The desired market value weighting of return.
Standards to which fiduciaries are held for the major asset classes that are
accountable. included in the management of the transparency risk
firm’s various balanced fund portfolios. The risk incurred by investors’ limited
step-up bond access to information about their
A bond that is underwritten with target date immunization alternative investments, including the
pre-defined (varying) coupon rates for In the pension industry, a means of fund’s operation, as well as its holdings
each year until maturity. The coupon protecting a bond portfolio from and performance.
rate is set below market for the first interest rate risk, where there is an
few years, but then crosses to above obligation to make a future payout on trust
market rates for the remainder of the a target date. Is a belief that those people on
bond’s term. whom we depend, whether by choice
top-down approach or circumstance, will meet the
straight-through processing An approach to investing that begins expectations we have placed on them.
A type of security trade processing with a macro and microeconomic
and portfolio management software analysis of trends and market forecasts trustee
that provides one continuous real-time in the global, North American and A person or entity that holds the
investment management database Canadian economies. The manager title to the property (the cash and
that links the firm’s front, middle and then selects the sectors that they securities) of a mutual fund on behalf
back offices. expect will outperform other sectors of the mutual fund’s unitholders.
within the expected economic outlook.
stratified sampling
See cellular sampling. tracking error
The standard deviation of the return U
style analysis difference between the portfolio
The study of style drift in a fund’s and the index when a manager is ultimate designated person (UDP)
holdings or returns over time. responsible for an index product.
The person within an investment
management firm who is responsible
style drift tracking error minimization to the self-regulatory organizations for
Occurs when a manager’s portfolio An approach that uses historical data the firm’s conduct and the supervision
strays from a specific investment to model the tracking error variance for of its employees.
management style. each bond in the index, then minimizes
the total tracking error in that model.

© CANADIAN SECURITIES INSTITUTE (2019)

 GLOSSARY G•9

value-oriented approach
A bottom-up approach to investing
that looks for undervalued securities,
with little focus on overall economic
and market conditions.

values
Beliefs that are long-lasting and guide
individual and corporate behaviours
and goals.

value system
A system in which the end and means
values mutually reinforce and support
each other.

© CANADIAN SECURITIES INSTITUTE (2019)