Portfolio Management Principles Flashcards

What is the 'efficient frontier' in modern portfolio theory?

Answer: The set of portfolios that offer the highest expected return for a given level of risk, or the lowest risk for a given expected return

Developed by Markowitz, the efficient frontier represents the set of optimal portfolios that offer maximum expected return for each level of risk. Portfolios below the frontier are inefficient — they could be improved by either increasing return or reducing risk.

What is the Capital Asset Pricing Model (CAPM) used for?

Answer: To determine the expected return of an asset based on its systematic risk (beta) relative to the market

CAPM provides a formula to estimate the expected return of an asset: Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate). It shows the relationship between systematic risk and expected return.

In portfolio construction, what is 'standard deviation' used to measure?

Answer: The total risk (volatility) of a portfolio or investment, measuring the dispersion of returns around the mean

Standard deviation measures the spread or dispersion of returns around the average return. A higher standard deviation indicates greater variability (volatility) of returns, which is used as a proxy for total risk in portfolio theory.

What does 'absolute return' mean as an investment objective?

Answer: Targeting a positive return regardless of market direction, rather than outperforming a benchmark

Absolute return strategies aim to deliver positive returns in all market conditions, unlike relative return strategies that aim to beat a benchmark. Hedge funds commonly pursue absolute return objectives using long/short positions and other strategies.

What is 'tracking error' in the context of index funds?

Answer: The degree to which a fund's returns deviate from its benchmark index

Tracking error measures the standard deviation of the difference between a fund's returns and its benchmark's returns. A low tracking error (close to zero) indicates the fund closely replicates its benchmark, important for passive/index funds.

What is the primary goal of 'liability-driven investing' (LDI)?

Answer: To manage assets specifically to meet future liabilities, such as pension obligations

LDI is an approach used primarily by pension funds and insurance companies to manage their assets in relation to their specific future liabilities. The portfolio is structured to ensure assets will meet known future obligations, often using bonds and interest rate derivatives.