Chapter 22: Portfolio Mangement (2) Flashcards
State the
- 2 conflicting objectives that may be faced by the manager of an investment fund established to cover liabilities
- 2 stages in the portfolio contrustion process
2 conflicting objectives faced by investment fund covering liabilities
- Ensuring security of liabilities (ie solvency) and stability of costs/profits
- Achieving high long term investment returns, to reduce costs/increase profits
- They may have some mis-matching to generate higher returns
2 stages of portfolio construction process
- Establishing strategic benchmark asset allocation
- Tactical implementation of strategy by selecting one of more managers and deciding appropriate level of risk they should take relative to strategic benchmark
List 15 factors influencing investment strategy that appeared in CA1
- Size of assets - absolutely and compared to liabilities
- Objectives of investor
- Uncertainty of existing liabilities
- Nature of existing liabilities
- Diversification
- Existing portfolio
- Restrictions on how fund may invest
- Term of existing liabilities
- Return from various asset classes
- Accural of future liabilities
- currency of existing liabilities
- Tax
- Other funds
- Risk appetite/tolerance
- Statutory valuation, solvency and accountancy requirements
Explain what is meant by each of the following
- Strategic risk
- active risk
- structural risk
Strategic risk
Risk that strategic benchmark under-performs relative to value of liabilities. Often quantified with reference to matching portfolio- portfolio deemed to most closely match liabilities
Active risk
For each individual specialist manager, active risk is risk that the fund under-performs relative to his paricular benchmark. Total active risk is risk that managers in aggregate under-performs relative to aggregate of individual benchmarks
Stuctural risk
Risk that aggregate of individual managers’ portfolio benchmarks under-performs relative strategic benchmark
Outline the two main uses of multifactor models in portfolio management
- Identifying mis-priced assets - by comparing the required return according to the model with expected reutrn based on the price
- Controlling exposure of portfolio to different risk factors, in order to match liabilities or track index
Explain what is meant by technical analysis and list its three main forms
- Attempts to predict future prices and yields based on past prices, yields and/or trading volumes
Three main forms
- Chartism
- mechancial trading rules
- relative strength analysis
Explain what a chartist does
- Tries to identify and trends in prices and/or yields by looking at charts
- Then takes action based on probaility that past pattern of behaviour will be repeated in future
Explain, with the aid of a simple example, how mechanical trading rules are used
- Trading signals given by set price movements and acted on mechanically
- although choice of trading rule is subjectivee, its subsequent implementation is not
- For example, share may be bought if it moves up by x% from previous low, or sold if it falls more than y% from previous high. If x% and y% are too small, any profits will be lost through expenses of excessive trading. If values are high, then substantial price movements will have occured before trade executed and some potential profits lost
Explain in detail how relative strength analysis works
- Examine performance of share relative to market as wholle or its own su-sector
- Can be used in two ways
- To attempt to identify change in relative strength at early stage. If this is considered unlikley to happen again in immediate future, then share may be sold. Based on belief in mean reversion
- To buy companies whose shares have out-performed in previous six months. Idea is that shares that have done well in fist six months will continue to do well in next six months as other investors see share doing well adn want to participate in extra performance. Based on belief in momentum effects
List three possible advantages and three possible disadvantages of technical analysis
Three possible advantages of technical analysis
- Quick and easy to collect data and carry it out
- Can be helpful with decisions on timing of investment
- May help you make short term trading profits
Three possible disadvantages of technical analysis
- Could distract investor’s attention from more important considerations such as long term value
- Instead of short term profits, you could end up making hefty losses
- Might encourage more active trading strategy increasing expense levels
Explain what is meant by risk budgeting
- Process of establishing overall investment risk to be taken anda where it is most efficient to take risk in order to maximise return
- Can be thought in two stages
- Deciding how to allocate maximum overall risk between strategic risk and total fund active risk
- Allocate total fund active risk across component portfolios, ie deciding how much risk each individual specialist fund manager can take
Outline what is done in each of the first steps in the risk budgeting process
First step in risk budgeting prociess
- EDefine ‘feasible set’ - set of asset classes that can be included in portfolio
- Obtain estimates of volatilities and covariance of eaach asset class
Second step in risk budgeting process
- Use asset - liability modelling to determine matching portfolio
- Perform value at risk calculationsd to determine that total risk budget
- Allocate total risk budget between strategic risk and total active risk
- determine investment strategy
- Allocate total active risk between different investment managers (and determine individual manager’s benchmark s and guildelines)
Outline the third and fourth steps in the risk budgeting process
Thrid step in the risk budgeting process
- Monitor risk exposures (Increases and decreases in values of positions) and changes in voloatilities and correlations
Fourth step in risk budgeting process
- Rebalance portfolio in response to hcanges in short term volatilities and corrations of assets
- Allocations are altered to keep overall portfolio within risk budget
Define
- Relative return
- Tracking error
- Backwards looking tracking error
- Forward looking tracking error
Relatiive return
Difference between portfolio return and benchmark return
Tracking error
Annualised standard deviation of relative return
Backwards - looking tracking error
Estimate of tracking error based on observed historical data from a recent past period. Measures average active risk taken over recent past perod
Forward looking tracking error
Estimate of standard deviation of returns (relative to benchmark) that porfoolio might experience in future if its current structure remains unaltered
Explain what is meant by
- Active money
- Information ratio
And state what each tells you
Active money
- Difference btween portfolio weighting of share/sector and index/benchmark weighting
- Loosely, larger active money positions indicate greater divergence from the benchmark and hence more risk relative to benchmark
- Doesn’t provide complete picture of risk versus the benchmark, as some stocks more likely to perform very different to benchmark then others (eg those with high betas)
Information ratio
- Ratio of mean of relative divided by standard deviation of relative return
- Indicates how efficiently additional ris can be converted into additional return
