Portfolio and Fund Management

Module Introduction and Overview

Contents
1 Introduction to the Module 2

2 The Module Author 3

3 Study Resources 3

4 Module Overview 4

5 Learning Outcomes 9
 Portfolio and Fund Management

1 Introduction to the Module

This module examines the principles and practice of portfolio management,
from the perspective of the individual investor, and the professional fund
manager employed by an institutional investor, such as a mutual fund, pen-
sion fund, or hedge fund. Over a period of decades there has been rapid and
far-reaching change in the investments industry. Deregulation and financial
liberalisation, and developments in information and communications technol-
ogy, have contributed to a massive expansion of financial markets and the
development of new trading strategies. The downside of these developments
was a financial crisis in the late 2000s of a magnitude not seen previously since
the 1920s and 1930s. Several of the causes of this crisis can be traced directly to
innovations in security design, trading strategies fuelled by leverage, a lack of
transparency, and a widespread attitude of complacency towards risk among
investors, financial intermediaries, and regulators.
The module uses and discusses several of the most important building
blocks of financial economics theory, including the capital asset pricing
model and the efficient markets hypothesis. A core principle running
through the module is that investment decisions are taken in a context
where higher returns can only be earned at a cost of accepting greater risk.
To make good investment decisions, the individual or professional investor
needs to consider their financial objectives or goals, their time horizons, and
their willingness to tolerate risk. The trade-off between reward and risk is a
recurring theme. We measure reward as the expected return on a security,
and risk is measured using the variance or the standard deviation of returns.
Many of the theoretical models and tools you will study in this module are
based on the idea that the behaviour of most competitive financial markets
approximates closely to the efficient markets hypothesis for most of the time.
In summary, the efficient markets hypothesis suggests that the prices of
financial securities incorporate all available information, so it is not possible
to make profits by analysing past prices. In actuality, markets are not always
efficient. You will consider explanations of market inefficiency from the area
of behavioural finance. You will also examine the extent to which it is
possible to make profits from exploiting pricing anomalies, when securities
are underpriced or overpriced, and whether trading strategies that are based
on an analysis of past price data can be profitable.
While you are studying this module, you will examine the major issues that
are of concern to all investors. The module will provide you with theoretical
knowledge and practical skills that are essential if you intend to pursue a
professional career in the investment industry, or if you hope to be success-
ful as a sophisticated private investor. The module will also be useful if you
wish to understand how investors, traders and the investment industry
operate. The style of presentation is predominantly non-technical, concen-
trating mainly on discussion of core principles and their practical
application. Formal mathematical and statistical content is kept to a mini-
mum level required for the development of some key concepts and tools.

2 University of London
 Module Introduction and Overview

2 The Module Author

John Goddard is Professor of Financial Economics and Deputy Head of
Bangor Business School in Bangor University. Originally trained as an
economist, he holds a Bachelor’s degree from Lancaster University, and a
Master’s from University of London. He worked for several years in life
insurance, before pursuing an academic career that includes previous
appointments at Leeds University, Abertay University and Swansea Univer-
sity. His areas of research include the economics of the banking industry,
financial markets and institutions, and the economics of professional foot-
ball. He has teaching experience in the areas of finance, economics and
statistics. He is co-author of the textbook Industrial Organization: Competition,
Strategy, and Policy (5th Edition. Pearson, 2017), and the introductory guide
Banking: A Very Short Introduction (Oxford University Press, 2016).

3 Study Resources
Study guide
This study guide is your main learning resource for the module as it directs
your study through eight study units. Each unit has recommended reading
either from the key text or from supplementary module readings to which
you will have access.

 Key text
In addition to the study guide, you will be assigned chapters in the follow-
ing key text, which is provided for you.
Zvi Bodie, Alex Kane & Alan J Marcus (2018) Investments. 11th Edition.
New York: McGraw-Hill Education.
The coverage of this book is broader than the content of the module, and you
will be directed to read selected chapters. Each unit of the module provides
guidance concerning the chapters and sections of the key text that will sup-
port your study of the topics in the unit. It is recommended that you read the
indicated chapters and sections of the key text in conjunction with the study
guide to strengthen your understanding. The key text includes many worked
examples, and illustrates how the tools of portfolio and fund management are
used in practice. The key text provides relatively less coverage of behavioural
finance (which you will study in Unit 5) and technical analysis (Unit 6). In
these units, more extensive explanation and analysis is provided in the study
guide and in the module readings.
The key text by Bodie, Kane and Marcus is written predominantly in a non-
mathematical and non-technical style. However, if you are especially interested
in the mathematical formulae and derivations underlying the material studied
in the units, these are provided in the book, usually in Appendices to the
relevant chapters. As noted, the book also contains extensive worked examples.

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 Portfolio and Fund Management

When you are directed to read from the book it will be useful for you to study
these examples to develop your understanding of the practical implementation
of the tools, methods and techniques covered in this module.

Module Readings
We also provide you with access to academic articles and other reports and
material that are assigned as core readings in the study guide. You are
expected to read them as an essential part of the module. We have selected
articles and reports which reinforce your understanding of the material in
the study guide and key text, and which also demonstrate how the methods
you are studying are applicable and relevant in the investment industry.

4 Module Overview
Unit 1 Financial Planning, Financial Instruments, Risk and Return
1.1 Introduction
1.2 Financial Objectives, Time Horizons and Risk Tolerance
1.3 Money Market Securities
1.4 Bonds
1.5 Equity
1.6 Derivatives
1.7 Property and Commodities
1.8 Rates of Interest and Rates of Return
1.9 Measuring Reward and Risk
1.10 Treasury Bills, Government Bonds and Equities: The Historical Record
1.11 Conclusion

Unit 2 Financial Intermediaries and Investment Companies

2.1 Introduction
2.2 Financial Intermediaries
2.3 Types of Investment Company
2.4 Specialised Investment Companies and Vehicles
2.5 Pension Funds
2.6 Conclusion

Unit 3 Stock Markets and Benchmarks

3.1 Introduction
3.2 Privately-Held and Publicly-Held Companies
3.3 Primary Securities Markets
3.4 Secondary Securities Markets
3.5 Special Types of Transaction on Secondary Markets
3.6 The World’s Major Stock Exchanges
3.7 Regulation of Financial Markets
3.8 Leading Stock Market Indexes
3.9 Conclusion

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 Module Introduction and Overview

Unit 4 Optimal Portfolio Selection

4.1 Introduction
4.2 Risk Aversion, and a Risk Adjusted Performance Measure
4.3 Probability Distributions for Returns
4.4 Portfolio Theory I: Portfolios Containing One or Two Risky Securities
4.5 Portfolio Theory II: Optimal Portfolio Selection for Portfolios of Many Risky Securities
4.6 Conclusion

Unit 5 Behavioural Finance

5.1 Introduction
5.2 Formation of Beliefs
5.3 Investor Preferences
5.4 Limits to Arbitrage
5.5 Applications of Behavioural Finance I: Aggregate Stock Market Puzzles
5.6 Applications of Behavioural Finance Ii: The Cross-Section of Stock Returns
5.7 Critique of Behavioural Finance
5.8 Conclusion

Unit 6 Technical Analysis

6.1 Introduction
6.2 Historical Foundations of Technical Analysis
6.3 Tools of Technical Analysis
6.4 Technical Trading Rules and Systems Based on Charts and Moving Averages
6.5 Evaluation of Technical Analysis
6.6 Conclusion

Unit 7 Passive and Active Portfolio Management

7.1 Introduction
7.2 Strategic and Tactical Asset Allocation
7.3 Fundamental Analysis
7.4 The Treynor–Black Single Index Model: Introduction
7.5 The Treynor–Black Model as a Tool for Portfolio Optimisation
7.6 The Black–Litterman Model
7.7 Conclusion

Unit 8 The Evaluation of Portfolio Performance

8.1 Introduction
8.2 Performance Evaluation: The Sharpe, Jensen and Treynor Measures
8.3 Performance Evaluation: Other Performance Measures
8.4 The Contribution of Market-Timing Ability to Performance
8.5 Performance Attribution
8.6 Style Analysis
8.7 Performance Evaluation for Hedge Funds
8.8 Conclusion
Unit 1 examines the financial instruments that are the building blocks of any
investment portfolio. These securities include risk-free, or very low risk
money market instruments, such as treasury bills and certificates of deposit.
The unit also considers government and corporate bonds, which are longer-

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term instruments that may range from virtually risk-free to high risk,
depending on the credit rating of the issuer. Moving further up the risk
spectrum, the unit considers corporate shares or equity. The owner of
corporate equity has an ownership stake in a listed company, and property
rights in any residual income that remains after all other creditors have been
reimbursed. The unit also considers derivatives, which are typically high-
risk instruments, whose payoffs derive from the value of other securities.
Property and commodities are relatively illiquid investment instruments
that may offer portfolio diversification benefits.
Unit 2 examines the financial intermediaries that are the key players in the
investment industry. These intermediaries act as go-betweens in financial
transactions, and facilitate the channelling of funds from lenders to borrow-
ers. Financial intermediaries include financial advisers, brokers, wealth
managers, and investment bankers. These companies provide their clients
with access to financial markets, as well as a range of information and
advisory services. Investors wishing to profit from exposure to instruments
such as equities, bonds, property or commodities do not always have to
purchase these assets directly, and you will see how financial intermediaries
provide investment vehicles such as unit investment trusts, mutual funds,
exchange-traded funds, and hedge funds. In Unit 2 you will also examine
pension funds: any individual who is a member of a pension fund has a
stake in a portfolio of pooled investments.
Unit 3 considers the financial markets in which securities are traded. The
unit distinguishes between primary markets for newly-issued securities, and
secondary markets, for the purchase and sale of securities that were issued
previously. In relation to primary markets, the unit considers initial public
offerings, which involve a privately-owned company offering shares for sale
to the public for the first time. Primary markets also include seasoned equity
offerings. These involve a publicly-traded company seeking to raise addi-
tional shareholder capital. In relation to secondary markets, the unit
examines over-the-counter markets, specialist markets, and Electronic
Communications Networks. You will see that secondary markets have been
transformed by the growth of electronic trading, which has created new
opportunities for trading at long distance, and for the development of
automated trading strategies such as algorithmic trading and high-
frequency trading. You will examine transactions in secondary markets
including buying on margin, and short selling. The unit briefly considers
several of the world’s most important stock markets, located in the US,
Western Europe and East Asia, and assesses how stock market indexes are
used as benchmarks for evaluating investment performance.
Units 1, 2 and 3 identify the main types of company, the financial instru-
ments, and the markets that comprise the investment industry.
Unit 4 examines the fundamental problem of selecting a portfolio of risky
and risk-free investments that provides the best possible combination of
potential reward and risk. The unit considers the theoretical solution to this

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 Module Introduction and Overview

portfolio optimisation problem first formalised by Harry Markowitz in the

1950s. The Markowitz portfolio theory demonstrates how the rational
investor should construct their optimal portfolio through diversification.
You will examine how a diversified portfolio is created by purchasing many
securities offering different combinations of expected return and risk, and
how this achieves a better reward-risk combination than would be obtained
by assigning the entire fund to the purchase of any single security. A key
insight in Unit 4 is that the optimal portfolio of risky assets is the same for all
investors regardless of their individual risk preferences. Once the optimal
risky portfolio is found, investors can create an overall portfolio that match-
es their risk preferences by combining the optimal risky portfolio with risk-
free investments. The unit also briefly considers the assumption in finance
theory that returns follow a normal distribution, and how to measure and
assess departures from normality.
The Markowitz portfolio theory (like much of mainstream finance theory), is
based on the assumption that participants in financial markets behave
rationally. It is assumed that stock prices always reflect the best available
information about fundamentals, and stock prices change only in response
to the arrival of new relevant information. Unit 5 challenges these proposi-
tions, and examines the predictions from behavioural finance. Behavioural
finance suggests that some trading activity in financial markets, and some
patterns in security prices, can be explained by models in which some agents
act in a manner that is not fully consistent with the assumptions of rational
behaviour. The behavioural finance literature draws on insights from
psychology to explain how agents form their beliefs, how their preferences
are defined, and how these beliefs and preferences influence their decisions.
This unit also considers ‘limits to arbitrage’. In mainstream finance theory,
arbitrage traders take advantage of pricing anomalies, and their trades
eliminate mispricing, restoring security prices to their fundamental values.
In Unit 5 you will see that if some agents are not completely rational, and
there are limits to arbitrage, this can have a substantial and long-lasting
impact on asset prices.
Unit 6 considers technical analysis. Technical analysts believe that future
stock price movements can be anticipated by analysing recurring patterns in
historical market data. Unit 6 examines the tools of technical analysis,
including recognition of historical patterns in price and volume data, and
calculation of moving averages, volatility measures, and other technical
indicators. You will also assess the investment strategies based on technical
analysis. The unit considers computer-based algorithmic trading strategies,
including high-frequency trading, which are an adaptation of technical
analysis. The unit examines the potential for making profits from technical
analysis, and discusses the argument from many academic financial econo-
mists who question the relevance and value of technical analysis.
Unit 7 considers passive and active portfolio management styles. A fund
manager following a passive style sets percentage targets for the weighting
or importance of broadly-defined asset classes in the portfolio, such as

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government bonds, corporate bonds, and equities. The unit shows how an
active portfolio management style involves varying these weightings. You
will examine the key elements in an active style, including security selection,
identifying securities that are mispriced using security or fundamental
analysis, and market timing. Market timing involves changing the composi-
tion of the portfolio in response to anticipated market movements or
fluctuations in economic conditions.
Unit 7 also examines some practical aspects of portfolio optimisation and
active fund management. The unit explains how the Markowitz approach to
portfolio optimisation can potentially be quite costly to implement, because
it involves estimation of many parameters relating to all the securities that
could be included in the optimal portfolio. The unit considers two alterna-
tive tools that greatly simplify the task of constructing the optimal portfolio,
and which are recommended for security selection and asset allocation. The
Treynor-Black single-index model examines the extent to which the returns
on individual securities are related to the returns on a market-index portfo-
lio, which greatly reduces the number of parameters to be estimated. The
Black-Litterman model allows the fund manager to modify the predictions
from the capital asset pricing model using their own views concerning the
expected performance of assets. You will examine the construction and
application of both of these models.
Unit 8 examines how to measure and evaluate investment performance. The
unit first considers the risk-adjusted performance measures that were
devised by several prominent early practitioners of financial economics,
including the Sharpe ratio, the Treynor measure, and Jensen’s alpha. The
unit also examines the information ratio, the M2 measure and the Morn-
ingstar risk-adjusted return. The unit then considers performance
attribution, which identifies how the decisions taken by a fund manager in
relation to asset allocation, security selection and market timing each con-
tribute to the fund’s overall performance. The unit also examines returns-
based style analysis. This is a tool for drawing inferences about a fund’s
investment style, by searching for similarities between the observed returns
for the fund, and the returns on market indices representing a range of
relevant asset classes. If a fund provides information about its style, this
technique can be used to check if the fund is actually following its declared
style. If a fund does not provide clear information about its investment style,
then inferences can be drawn about the style most likely to have produced
the fund’s observed historical returns. The unit also highlights the particular
challenges for performance evaluation of hedge funds. The investment style
of hedge funds is usually opaque and variable, and hedge funds adopt
unconventional investment strategies and extreme risk profiles. These
factors mean the performance of hedge funds cannot be adequately assessed
using the standard measures

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 Module Introduction and Overview

5 Learning Outcomes
When you have completed your study of this module, you will be able to:
• demonstrate knowledge of the types and functions of financial
instruments, financial intermediaries and financial markets
• explain the use of Markowitz portfolio theory in constructing an
investment portfolio that delivers an investor’s preferred combination
of expected return and risk, and assess the limitations of portfolio
theory as a practical tool for portfolio optimisation
• identify patterns of trading and asset prices that are inconsistent with
the predictions of rational behaviour and the efficient markets
hypothesis, and critically evaluate the explanation of these
inconsistencies provided by behavioural finance
• explain the main tools of technical analysis and evaluate investment
strategies derived from technical analysis
• discuss the distinction between passive and active investment styles,
and critically evaluate the usefulness of the Treynor-Black and Black-
Litterman models as practical tools for active investment
• assess the applicability of performance measures; attribute investment
performance to components deriving from asset allocation, security
selection and market timing; and explain the use of style analysis to
identify a fund’s investment style.

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