5 C's of Credit Investing

1. Character - credit history of the borrower, reputation etc

2. Capacity - ability to finance debt i.e. net debt/ EBITDA, interest cover etc

3. Capital - factor of shareholders putting up capital. e.g. the size of the downpayment on a house

4. Collateral - assets the creditor can potentially fall back on in an event of default

5. Conditions - e.g. covenants that protect the creditor such as restriction on dividends, maintenance of interest rate cover or net debt to EBITDA ratio

Taxation Summary Table

The below table gives a brief summary of the type of taxation and how they vary with pre-tax returns and investment time horizon.

Tax Type	Formula	As n increases, tax drag:	As r increases, tax drag:
Accrual taxes	FVIF = (1+r(1-t))^N	% increases and amount increases	% increases and amount increases
Deferred capital gains tax	FVIF =(1-tcg)x(1+r)^N + tcg x B	Amount increases and % increase If B<1 then % > t If B = 1 then % = t If B>1 then % < t	Amount increases and % increase If B<1 then % > t If B = 1 then % = t If B>1 then % < t
Annual wealth tax	[(1+r)*(1-tw)]^N	Amount increases and % increases	Amount increases but % decreases
Blended taxation	wattr = pd x td + pi x ti + pcg x tcg R = r *(1-wattr) T = tcg x (1-pi-pd-pcg) / (1-wattr) FVIF = (1-T) *(1+R)^N + T – (1-B) x tcg

Accrual Equivalent After Tax Return = (EOP Value/BOP Value)^(1/N)-1

Foundations 101

Foundations and endowments can be grouped together as insitutions providing support for non-profit activities.

Endowments are typically owned by non-profit institutions such as universities e.g. Harvard University Endowment and are typically viewed as very long term oriented.

Foundations are funded by gifts and investment assets and typically are setup for some specific purpose e.g. funding a scholarship

Private foundations are created by a single donor with specific goals and in the US, the tax systems makes it necessary to have minimum spending levels in order to maintain the privleged tax status. E.g. Gates & Rockefeller foundations. The spending requirement reduces the ability of the donors to use the foundation as a tax shelter.

The endowments are usually created over time via gifts and contributions. The Yale, Harvard and Princeton endowments were grown over centuries.

Foundation Type	Description	Sources of Funds	Decision Making Authority	Spending Requirement
Independent (private or family)	Independent grant making organization	From individual or family	Donor or Trustees	At least 5% of average asset value
Company sponsored	Legally independent, grant making	Annual contributions from profit making corporation or an endowment	Board controlled by sponsors executives	At least 5%
Operating foundation	Provides direct service to a non-profit (instead of grants)	Individual or family	Independent board	Must use 85% of interest and dividend income for institutions programs. In some cases 3.3%
Community foundation	Publicly supported/type of charity	Multiple, public	Board of directors	None

Of the crucial differences it is also noteworthy to mention that foundation tend to have one initial contribution and then exist on the investment income of the contributed assets. Endowments tend to have additional contributions made to them over time and dont face the requirement of a spending rate in the same way as foundations face.

SML and CML

Behavioural Finance Concepts

Prospect Theory - alternative to utility theory, value is assigned to changes in net wealth instead of total wealth and probabilities are replaced by decision weights. Decisions weights are lower than probabilities apart from low probability events in which case it is reversed. (explain why people buy insurance and lottery tickets) Prospect theory points out also that people are not risk averse but loss averse i.e. their losses matter more than the gains.

Bounded Rationality - assumes investors are rational but are subject to limitations of knowledge and cognitive error. Limitation in knowledge and cognitive error lead to satisficing eg rule of thumb decision making

Rational Economic Man = assumes key traditional finance assumption that people have perfect informatio, are perfectly self interested and are fully rational

Utility Theory = traditional finance theory that people maximize their utility subject to a budget constraint.

Utility Theory Axioms = continuiting (if a>b>c then b can be expressed as a combination of a and c), completeness (a is either = or > or < b) , transitivity (if a>b and b>c then a>c), independence (if c is mutually exclusive from a and b, then a>b implies a+c>b+c)

Decision Theory - concerned with identifying probabilities, values and uncertainties of outcomes relevant for a given decision with a goal of using infomation to identify an optimal decision (normative = ideal decision)

Behavioural Portfolio Theory - as compared to the modern portfolio theory under BPT investors construct portfolios in layers and expectations of return and risk profile vary between these layers.

Life Cycle Theory - people are assumed to save and spend money rationally over their lifetime in line with their short term and long term plans.

Behavioural Life Cycle Theory - life cycle theory that incorporates self control, mental accounting and framing biases

Traditional finance theory - assumes rational economic man, that investors are risk averse utility maximizers

Friedman-Savage Double Inflection Utility Function - investors are risk averse at low wealth levels, risk seeking at middle wealth levels and risk averse at high level of wealth.

Adaptive Market Hypothesis - applying theories of competition, adaptation and natural selection to reconcile the efficient market hypothesis. e.g. LTCM used arbitrage strategies that became more popular which led to more competition and LTCM's inability to adapt led to its failure.

Behavioral Asset Pricing - suggests to add a sentiment risk factor to the discount rate i.e. not only account for time value of money and fundamental asset risk

Greeks & Options

Delta of an option is the rate of change of the option price to a $1 change in the underlying price. Delta of a call option ranges from zero and 1 and the Delta of a put option ranges from zero to -1. I.e. put option delta is always negative while the call option delta is always positive.

if the call delta is 0.5, then a $1 increase in the price of the stock will increase the price of the option by $0.5

The delta is the sensitivity of the options price to the price of the underlying which is analogous to the bond price's sensitivity to the bond duration and the stocks sensitivity to the market as manifested by the stock beta.

Theta of an option represents the sensitivity of the option price to the change in time. Theta values are always negative for long options positions.

For example if theta is -0.5 then for every day the option will lose $0.5 in price.

Gamma is the sensitivity of the options delta to the underlying price. E.g. if Gamma is 0.5, then if the underlying asset price increases by $1 then delta will increase by 0.5$

Gamma = (change in delta)/(change in the underlying asset price)

Gamma is the highest value when the option is trading at the money. 

Vega - measures the change in the options price that would result from a 1% change in the implied volatility of the underlying security.

Price of the Underlying	At the money	Deep out of the money	Range	Short options	Other notes
Delta	Call options have delta of 0.5 Put options have delta of -0.5	Call & put options tend to have delta of zero especially closer to expiration	(0-1) for call options and (-1-0) for put options	Opposite sign to long positions	Deep in the money calls have delta close to 1 Deep in the money put options have delta close to -1
Gamma	highest	Zero	Always positive or zero	Negative	Gamma is also high closer to option expiration. Gamma is highest when the option is at the money
Theta	Highest for short term options	lower	Negative for long calls and long puts	Positive for short calls and puts	Long term options have low theta High volatility stocks have high theta

• deep in the money calls have delta of 1 and deep in the money puts have delta of -1
• if a long put and long call have identical features, then the sum of the absolute values of deltas will equal 1
• a call option on EUR/USD is identical to a put option on USD/EUR

Hedge Fund Strategies List and Terminology

1. Portable Alpha - is separating an active managers alpha, the return from security selection within an asset class from beta. Typically this is done by using derivatives to eliminate beta from the exposure. The beta exposure is added from a different asset class. Typically a specialist manager can generate alpha in one country say Turkey while a US investor would take beta exposure to the S&P 500

2. Alpha Beta Separation - separating a portfolio into a strictly passive (beta) portfolio such as an index and an alpha seeking portfolio, e.g. market neutral fund. Here the alpha and beta are still generated based on same index or asset class.

3. Market Neutral - shorts and longs matched in portfolio to produce overall beta zero portfolio that is not correlated the market. The goal is to generate alpha on the long and short side, generating an absolute return uncorrelated with the market. Allocating to this strategy given its lower correlation with the market would be a good diversify to a portfolio that has assets that are correlated with the market.

4. Long Short - traditional hedge fund strategy that combine long and short positions and leverage

5. Global Macro - investing across the liquid asset asset classes based on macroeconomic principals and top-down approach.

6. Event Driven - includes Risk M&A Arbitrage and Distressed Securities

7. Managed Futures - carried out normally as commodity pools or commodity advisor funds (CTAs). These managers take direction bets on the price direction of commodities and interest rates.

8. Short Extension Strategy - long short strategy whereby the Longs would constitute a greater exposure than the shorts. e.g. long 100% and short 20%

9. Pairs Trading - two securities are traded, one long and one short with equal matching amounts. E.g. one could go long one stock and short another for the same dollar amount in the same industry with a view that one firm is better positions on the market or for some reason is likely to outperform thus generating alpha.

10. Equitizing - giving systematic risk to a market neutral portfolio by using derivatives. ETFs may be another insrument of equitizing the portfolio.

11. Completeness Fund - passive or semi-active style that has the same risk and characteristics as the index which still generates value added.

Non- Financial Risks

Operations Risk - Risks of human error, fraud or misconduct that were failed to be prevented by internal controls. Natural disasters are also included.

mitigation: independent audits of systems used to mitigate risk (both internal and external), remote back up systems

Model Risk - risk of using a model to monitor investments eg model does not take into account relevant variables for he task.

mitigation: regularly review model assumptions, list of variables, making sure the correct-upto date and correctly adjusted inputs are used

Regulatory Risk - the risk that laws or regulations will change and affect the nature of an existing or planned transaction. Regulatory risk for transactions increases with the number of jurisdictions that they must comply with.

Herstatt Risk or Settlement Risk - risk that the counterparty cannot make a required payment or delivery. The risk is named after a German bank that failed to deliver on tranactions it initiated during the day after it was shut down by regulators.

Legal Risk - the risk that the counterparty does not honor a contract or the contract or a provision is not enforceabe. This one also includes the risk of a lawsuit brought by the client or the counterparty.
Legal risk tends to increase when counterparties are located in different countries.

Tax Risk - risk of changes in tax laws or the enforcement of existing ones. Complex securities, structures or deals increases tax risk.

Accounting Risk - risk arising from difference in accounting rules and their application. Risks could arise from aggressive accounting, managed earnings or disparaties of in accounting rules.

Sovereign Risk - risk that the government defaults on its debt either through lack of willingness or abiliy to pay

Political Risk - either minor or major changes in government that affect the invetment environment within the country.

ESG Risk - Environmental, Social and Governance risks. Social risk ivolves changes in workplace standards, human resource practices and employee policies and procedures.

Performance netting - the loss in return ot the investor when paying for positive performance in one portfolio and losing as much in another portfolio.

Mean Variance Optimization Limitations

Mean Variance Optimization (MVO) is currently one of the mainstream asset allocation approaches used in modern finance and is a core component of the modern portfolio theory. The theory distills securities to just return and risk (as measured by security price standard deviation) and assumes investors seek the highest return for the lowest level of risk (again as measured by the standard deviation of portfolio returns)

Today computer programs take into account the correlations between asset class returns to identify combinations of asset classes that offer highest possible returns for a given level of acceptable risk.

Key assumptions behind MVO:

1. Risk averse investors
2. No taxes or transaction costs
3. Investor returns are normally distributed
4. All returns, correlations and variances are known

As you can see these assumptions are extremely strong and discredit the approach significantly

Here are just a few criticisms

(CRISLS)

1. Concentrated positions - MVO produces highly concentrated asset allocation positions that may not be acceptable for investors

2. Investors care not only about returns and variance but other factors as well

3. The MVO models are highly sensitive to small changes in the inputs

4.  Sources of risk may be different so in essence the MVO asset allocation could be poorly diversified due to high exposure to a single risk source.

5. No Liabilities - MVO does not have a mechanism to account for liabilities

6. Single period model

Asset Classes - What Are They?

Asset allocation and the theory behind it is a critical cornerstone in portfolio management today but behind all the discussions on asset allocation we should keep in mind the key properties to look for in identifying a true asset class:

(DICHM)

1. Diversifying - the name says it all really. The asset class identified should not be 100% correlated with any other

2. Investable - there is just no point in identifying an asset class that one cannot gain any exposure to

3. Group Global Investable Assets: Together with other asset classes the group should constitute all or close to all investable global assets.

4. Homogenous - the assets within an identified asset class should behave in similar ways. i.e. don't put corporate bonds with inflation linked fixed income securities together in one asset class as they behave very differently (when rates rise due to higher inflation, corporate bonds will likely fall significantly more than inflation linked securities that will increase coupons in line with inflation)

5. Mutually exclusive - the asset class should not some of the assets that are already in another asset class

What Makes a Good Benchmark?

Whether you are managing a Fund or just a personal portfolio, selecting the right benchmark could be important as you seek to evaluate your own performance. Below are the core characteristics to look for in a benchmark.

For the sake of example, I add a little personal comment on how I feel the S&P 500 works as a benchmark to Berkshire Hathaway stock returns given that they use it as their guide.

• Appropriate (A) 

the benchmark needs to be appropriate. you can't use a basket of US large cap insurance stocks to track performance of an african insurance stock. here it is a question whether S&P 500 with a sizable weighting in technology is appropriate for BRK which is a collection of companies with relatively little technology exposure. It kind of feels that S&P 500 does not fit well here

• Investable (I)

S&P 500 does well here. You can simply use a low cost ETF such as the Vanguard VOO

• Measurable (M)

S&P 500 stock returns are openly available and in terms of being measurable there clearly is no argument here

• Accountability (A)

warren buffet did say that his managers are incentivized to outperform the S&P 500 and he himself as put his reputation on the line in order to succeed in this task. certainly these guys "own" their benchmark

• Representative of the Investor's Views (R)

this one is more difficult. Berkshire Hathaway is clearly focused on high quality large cap value as a style of investing and research suggests that this style does closely match the BRK performance. it is therefore difficult to take S&P 500 - a broad index of US firms as representative of the BRK style of investing and approach. BRK also has some investments abroad which is also a factor to consider

• Unambiguous (U)

the S&P 500 stocks are closely followed and rarely do companies get kicked out or included in the index. certainly it does not feel ambiguous 

• Set Out in Advance (S)

Warren Buffet has set out S&P 500 as the benchmark many many years ago. if I'm not mistaken from the outset. It certainly seems like the benchmark clears this hurdle