Case Studies in Institutional Portfolio Management
You've essentially made it to the end of the curriculum. Congratulations!
Besides a continued review of the ethics sections, case studies are all that remain. Looking through these case studies can give you some good insight as to what you might expect on the exam. How do case studies directly relate to the exam?
It does, but that doesn't relate directly to case studies.
Right!
It has vignettes for each set of multiple choice questions or essays, and that's why case studies can be useful. You will be answering questions in Level III based on these "mini case studies."
The QUINCO case study takes you through several aspects of portfolio management with an eye on liquidity issues specifically. What's a logical first step in determining if liquidity is adequate?
Yes. You have to decide how liquid is "highly liquid" vs. "semi-liquid," and so on. That's a time to cash schedule that might look like the one used in the case study:
| Time to Cash | Liquidity Classification |
|-----|-----|
| Less than a Week | Highly Liquid |
| Less than a Quarter | Liquid |
| Less than a Year | Semi-liquid |
| More than a Year | Illiquid |
Actually that's the second step. There's something else that needs to be done first.
Actually, that's the third step.
How would you expect this time-to-cash table to compare to those of other institutional investors?
Unlikely.
Probably, yes.
Each institutional investor will have categories of liquidity that are useful for its own situation, and then liquidity budgeting can take place. It could look something like the case study sample:
| Time to Cash | Liquidity Classification | Liquidity Budget as % of Portfolio |
|-----|-----|-----|
| Less than a Week | Highly Liquid | At least 10% |
| Less than a Quarter | Liquid | At least 30% |
| Less than a Year | Semi-liquid | At least 50% |
| More than a Year | Illiquid | At most 50% |
How would a manager need to then budget liquidity?
Not really. Equity is an asset class, but there are very liquid and very illiquid securities within this realm.
Right.
Asset class isn't enough. You have to get down to the specifics of a particular investment to place it in the liquidity profile of the portfolio.
That's not it. There are varied expected returns in the investment universe, but this alone doesn't directly relate to liquidity.
Then of course there is rebalancing to consider. If a portfolio gets tilted too heavily toward equities, then the manager might want to reduce this exposure. Would derivatives ever be useful for this?
Absolutely.
Actually, they would be.
How could derivatives be useful for rebalancing?
Not really. If you have too many equities, you can always sell some.
Exactly. A manager very well may choose to sell a futures contract on something similar to the overexposure held in order to rebalance. A fund like QUINCO has multiple managers each with their own allocation, and futures can be useful in this regard as well. Instead of taking some equity capital away from the manager, just use a derivative to rebalance and leave the portfolio in process.
That's rather ambiguous. If you use derivatives that are designed to match the exposure of some underlying, you shouldn't expect higher returns. If so, no one would purchase the underlying.
In fact, if an equity fund manager allocated to relatively illiquid securities, how might you expect returns to be affected, all else equal?
There's really no reason to expect this.
Yes. There should be an illiquidity premium expected for illiquid investments. That's only fair.
Of course, illiquidity is a risk, and it can harm you. The 2008 financial crisis taught many people a painful lesson in liquidity. It tends to disappear in bad times, and that's why stress testing a portfolio is necessary; a manager needs to know what will happen in a crisis scenario. Without proper liquidity management, a manager can suffer spectacular losses, and may be unfortunate enough to end up as a future case study!
Actually, they *should* be affected. Think of illiquidity as just another risk.
To summarize:
[[summary]]
The exam has multiple choice questions
The exam has vignettes and essays
Defining terms
Liquidity budgeting
Liquidity profiling of the portfolio
It's the same everywhere
All investors have their own
By asset class
By investment
By expected returns
Yes
No
They offer needed exposure that can't be obtained in the equity markets
They allow the manager to balance exposures of less-liquid assets with a liquid instrument
They allow the manager to obtain higher returns from the derivatives than equities offer themselves
Returns should be lower
Returns should be higher
Returns should be unaffected
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