Chapter 17: Investment management Flashcards
(20 cards)
Active investment management
Active management is where the manager has few restrictions on the choice of investments, perhaps just a broad benchmark of asset classes.
This enables the manager to make judgements regarding the future performance of individual investments, both in the long term and the short term.
Active management is generally expected to produce greater returns due to the freedom to apply judgement. However, this is likely to be offset by:
* the extra costs involved in more regular transactions, particularly when attempting to make short-term gains.
* the risk that the manager’s judgement is wrong and so the returns are lower.
Producing greater returns will not be possible if the investment market in question is efficient.
An efficient market is one in which asset prices accurately reflect all available and relevant information at all times.
Passive investment management
Passive investment management is the holding of assets that closely reflect those underlying a certain index or specific benchmark.
The manager has little freedom to choose investments.
Passive investment is not entirely risk-free as the index may perform badly or there may be tracking errors.
Passive investment management:
+ cheaper (not paying for active skills, such as dealing and research)
+ expected to be less volatile (relative to benchmark)
- limited upside potential
- limited to asset classes where suitable benchmark exists.
- require belief in efficient markets.
List 6 factors to consider before making a tactical asset switch
- The expected extra returns to be made relative to the additional risk (if any)
- Constraints on the changes that can be made to the portfolio
- The expenses of making the switch
- The problems of switching a large portfolio of assets
- The tax liability arising if a capital gain is crystallised
- The difficulty of carrying out the switch at a good time
The ability to absorb the extra risk is also relevant
Partial solution to gain exposure immediately is through derivatives
Tactical decisions involve short-term switching between investments in pursuit of higher returns.
Define “risk budgeting”
The term risk budgeting refers to the process of establishing how much risk should be taken and where it is the most efficient to take the risk (in order to maximise return)
The risk budgeting process has 2 parts:
1. deciding how to allocate the maximum permitted overall risk between active and strategic risk
2. Allocating the total active risk budget across the component portfolios
Risk budgeting is, therefore, an investment style where asset allocations are based on an asset’s risk contribution to the portfolio as well as on the asset’s expected return.
Overall risk = strategic risk + active risk + structural risk
The key focus when setting the strategic asset allocation is the risk toleranc of the stakeholders in the fund.
Strategic risk
The risk of poor performance of the strategic benchmark relative to the value of the liabilities.
Active risk
The risk of underperforming if the fund managers do not invest exactly in line with the individual benchmarks as they are given.
Structural risk
The risk of underperformance if the sum of the individual benchmarks given to fund managers does not add up to the strategic benchmark.
What are the key determinants deciding how much strategic and active risk to take?
The key question on strategic risk is risk tolerance of the stakeholders in the fund. This is the systematic risk they are prepared to take on in the attempt to increase long term returns.
The key question on active risk is whether it is believed that active management generates positive excess returns.
What are the 2 conflicting objectives faced by an investment fund established to cover liabilities?
- To ensure security, i.e. to meet the liabilities
- To achieve high long term investment returns
Give 3 reasons why a provider’s investment strategy should be regularly monitored
- Liabilities change over time
- The funding level of a scheme or free asset position of a company changes over time, affecting the level of matching required
- Monitoring helps identify whether the fund manager’s performance is in line with that of other funds.
Outline the considerations when setting investment performance objectives
- An investment fund should only be compared against similar funds with similar objectives and restrictions on the manager, not directly to the generality of funds.
- One of the best benchmarks to use is the return that would have been achieved by an index fund, which had maintained the asset allocation proportions set in the fund manager’s benchmark
- It is important to note any other constraints on the manager, e.g. a shortage of cashflow or the timing of cash inflows and disinvestments
Define 2 measures of active risk
- Historic (or backward-looking) tracking error, i.e. annualised standard deviation of difference between actual and benchmark returns (used for equity portfolios)
- Forward-looking tracking error, i.e. estimated standard deviation of relative returns if the current portfolio was unaltered.
List other investment risks, outlining how each might be measured
- Strategic asset allocation risk - measured using forward or backward looking tracking error approaches, comparing strategic allocation with target (liability-matched) allocation.
- Duration risk - measured using forward or backward looking tracking error approaches
- Counterparty, interest rate and equity market risk - measured as the amount of capital that has to be held against that particular risk, possibly relative to that required for a target portfolio.
Allowance should be made for the benefits of diversification across risks.
Describe a simple method for measuring the performance of a fund manager against their allocated benchmark, including areas where care needs to be taken.
Input all cashflows into and out of the fund to a spreadsheet that also holds the daily values of the benchmark.
Calculate the value of the fund over a chosen period on the basis that it had been invested in the benchmark rather than in the actual assets held, and compare this with the actual fund value achieved.
Care needs to be taken in relation to:
* the treatment of income, and in particular whether the benchmark index includes reinvestment of income or is capital only, taking into account whether the manager is assessed on capital or total investment performance.
* the allowance for fees.
A decision is needed on how frequently performance is monitored.
An analysis of reasons for the difference in fund value could be sought from the manager.
List 2 methods of measuring the rate of return on an investment portfolio
- Money weighted rate of return (MWRR)
- Time weighted rate of return (TWRR)
(be able to compare and contrast both the uses and disadvantages of these two)
Define MWRR
A money-weighted rate of return (MWRR) is identical in concept to an internal rate of return: it is the discount rate at which the present value of inflows = present value of outflows in a portfolio.
The MWRR allows for all cashflows and their timing, and is the same approach as described above.
The MWRR only takes account of new money into the fund or money disinvested by the fund. Any cashflows generated by the fund itself are ignored.
What is the main disadvantage of MWRR?
The MWRR factors in all cashflows, including contributions and withdrawals. Assuming a MWRR is calculated over many periods, the formula will tend to place a greater weight on the performance in periods when the account size is highest.
If a manager outperforms the benchmark for a long period when an account is small, and then the manager has a short period of underperformance, the money-weighted measure may not treat the manager fairly over the whole period.
Define TWRR
Deposits and withdrawals are usually outside a manager’s control; thus a better performance measurement tool is needed to judge a manager more fairly and allow for comparisons with peers - a measurement tool that will isolate the investment actions, and not penalise for deposit / withdrawal activity.
The time-weighted rate of return (TWRR) is the preferred industry standard as it is not sensitive to contributions or withdrawals
What is the main disadvantage of TWRR?
Using the TWRR will not identify the manager who has a skill at managing small funds and is weak at managing large funds, or vice versa.
The MWRR places greater weighting on the periods when the fund size is largest.
Explain why it can be difficult to assess the investment performance of a CIS?
CIS’s have a daily pricing point. This is the time of day at which the values of the underlying assets in the scheme are captured.
Intra-day movements in certain markets can be material and so to make a fair assessment of the scheme manager it is necessary to capture the relevant benchmark indices at the same time of day as the pricing point.
Not all market indices are available publically on a continuous basis.
