Smaller funds often lack the expertise and governance structure to invest in complex strategies, and therefore, often face a problem of how to achieve an adequate level of diversification. Larger portfolios can generally access greater management expertise in the governance capacity, allowing them to consider complex strategies that smaller funds cannot. Their larger capital base also enables investment in accounts with relatively high minimum investment requirements. This allows large funds to achieve higher levels of diversification.

As the size of the fund increases, the per-participant cost of the internal governance infrastructure decreases, giving the fund a competitive advantage in private equity, hedge fund, and infrastructure investing.

A small-cap manager may suffer diseconomies of scale because of the following:

– Larger trades have increased price impact.
– The inflow of capital may encourage managers to abandon their core strategies.
– The need for increased numbers of staff may slow the decision-making process.

A potential solution is to split the allocation among several managers. However, identifying and monitoring suitable managers is an added burden and cost.

The key to successfully addressing the liquidity constraint for a portfolio is to integrate the needs of the owner and the characteristics of the asset class. Some owners require extremely high levels of liquidity and hence typically invest in high-quality, short-term, liquid assets. Other owners with lower needs and much longer time horizons can take advantage of the illiquidity premium inherent in alternative investments, such as real estate and infrastructure.

Time horizon is the duration of time that an investor plans to hold a security. A portfolio’s time horizon is defined by a liability to be paid or a goal to be funded at a future date. Asset allocations must consider the horizons defined by each liability and goal, as well as adapting to the changing mix of assets and liabilities as time progresses.

Structural (consistent, as opposed to one-time) government policies that can facilitate long-term growth include the following:

– Minimal government interference with free markets.
– Development of infrastructure and human capital, including education and health care.
– Facilitate competition in the private sector.
– Sound fiscal policy.
– Sound tax policies.

The association between the government budget and current account deficits is called the twin deficit problem. Economies that have both a government deficit and a current account deficit are often referred to as having “twin deficits.”

The government deficit may be financed with excessive borrowing in foreign markets. This borrowing in foreign (rather than domestic) markets helps to finance the ability to import more than is exported and, support higher but unsustainable economic growth.

There are several potential outcomes of unsustainable economic growth caused by borrowing in foreign (rather than domestic) markets to finance the ability to import more than is exported. These outcomes include the following:

– The government deficit can be financed by printing money, which leads to high inflation.
– The excessive borrowing can stop, leading to a substantial cutback in spending by the government and consumers.
– The government deficit can be financed with excessive domestic borrowing by the government, which crowds out businesses borrowing to finance business investment.
– The currency can devalue when foreign investors are no longer willing to hold the debt.

Unanticipated events that occur outside the normal course of an economy are referred to as exogenous shocks. Since the events are unanticipated, they are not already built into current market prices, whereas normal trends in an economy, which would be considered endogenous, are built into market prices.

Exogenous shocks can be caused by different factors, such as natural disasters, political events, or changes in government policies. Although positive shocks are not unknown, exogenous shocks usually produce a negative impact on an economy and often times spread to other countries.

Contagion refers to the process of the spread of a negative impact on an economy to other countries. Exogenous shocks usually produce a negative impact on an economy and often times spread to other countries. Contagions are named as such for their potential to spread quickly and (seemingly) unexpectedly.

Many emerging markets require a heavy investment in physical and human (e.g., education) infrastructure. To finance this infrastructure, many emerging countries are dependent on foreign borrowing, which can later create crisis situations in their economy, currency, and financial markets.

Emerging markets offer the investor high returns at the expense of higher risk. For the bond investor, the primary risk is credit risk. Credit risk questions if the country has the capacity and willingness to pay back its debt.

There are six questions potential investors should ask themselves before committing funds to these markets. These questions are as follows:

– Does the country have responsible fiscal and monetary policies?
– What is the expected growth?
– Can the country maintain a stable, appropriate currency value?
– Is the country too highly leveraged?
– What is the level of foreign exchange reserves relative to short-term debt?
– What is the government’s stance regarding structural reform?

The traditional accounting balance sheet encompasses an organization’s assets, liabilities, and owner’s equity. It is used by accountants to illustrate the financial position of an organization. Nonfinancial assets and liabilities are not included in traditional balance sheets.

Investing in a bond market index fund provides low cost diversification and an alternative to active fixed-income management. Their goal is to minimize tracking error.

Tracking error is the standard deviation of the portfolio’s active return (portfolio return − benchmark return). Tracking error is also known as tracking risk or active risk. Tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. The tracking error can be viewed as an indicator of how actively a fund is managed and its corresponding risk level.

Forward contracts are preferred for currency hedging because of the following reasons:

– Forwards can be customized, while futures contracts are standardized.
– Forwards are available for almost any currency pair, while futures trade in size for only a limited number of currencies.
– Futures contracts require margin which adds operational complexity and can require periodic cash flows.
– Trading volume of FX forwards and swaps dwarfs that of FX futures, providing better liquidity.

A hedge can be a static hedge or dynamic. The main difference between a static and a dynamic hedge is that the static hedge is established and held until expiration, while a dynamic hedge is periodically rebalanced.

Roll yield refers to a return from the movement of the forward price over time toward the spot price of an asset. It can be thought of as the profit or loss on a forward or futures contract if the spot price is unchanged at contract expiration Hedging exposes the portfolio to roll yield or roll return.

A negative rate is defined as a net payment made to keep money on deposit at a financial institution or payment of a net fee to invest in short-term instruments. Negative interest rates were generally considered a hypothetical curiosity before the 2007–2009 financial crises.

The permanent income hypothesis asserts that consumer spending is mostly driven by long-run income expectations, not cyclical swings in wealth. This leads to countercyclical behavior, which dampens the business cycle. If income temporarily declines, consumers continue to spend (from savings) as longterm income expectations are more stable.

A basic model for forecasting trend economic growth focuses on the following:

– Growth in labor input based on growth in the labor force and labor participation.
– Growth in the capital.
– Growth in total factor productivity.

The wealth effect suggests consumers spend more when wealth increases and less when it decreases. The idea is that consumers feel more financially secure and confident about their wealth when their homes or investment portfolios increase in value. The wealth effect would contribute to swings between higher and lower spending and would amplify swings in the business cycle.

Investors select asset classes based on their desired exposure to common risk factors. Examples of risk factors include volatility, liquidity, inflation, interest rates, duration, foreign exchange, and default risk. Risk factor exposures may overlap across multiple asset classes.

Calendar rebalancing is the rebalancing of a portfolio to its strategic allocation on a predetermined, regular basis (e.g., monthly or quarterly). Generally, the frequency of rebalancing depends on the volatility of the portfolio, but sometimes rebalancing is scheduled to coincide with review dates.

With range-based balancing, rebalancing is triggered by changes in value rather than calendar dates. When applying range-based rebalancing, the following questions need to be addressed:

– Who is ultimately responsible for rebalancing the portfolio?
– How frequently should the portfolio be monitored for rebalancing decisions?
– What is the size of the rebalancing corridors?
– Should rebalancing to target weights be fully or only partially corrected?

Deviations from strategic asset allocation due to short-term capital market expectations is called TAA. Tactical asset allocation (TAA) is an active management strategy that deviates from the strategic asset allocation (SAA) to take advantage of perceived short-term opportunities in the market. The motives for TAA may include active management and adding alpha.

There are three types of asset allocation approaches. They are as follows:

– Asset-only approaches. They make asset allocation decisions based on the investor’s assets.
– Liability-relative approaches. They involve asset allocation decisions based on funding liabilities.
– Goals-based approaches. They are geared toward asset allocations for subportfolios, which help an individual achieve lifestyle and aspirational financial objectives.