Chapter 17: Investment management Flashcards
(22 cards)
What is 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.
Having identified the strategic asset allocation, an active approach involves actively seeking out under- or over-priced assets, which can then be traded in an attempt to enhance investment returns.
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 and the risk that the manager’s judgement is wrong.
Explain what is meant by an efficient investment market
An efficient investment market is one in which asset prices accurately reflect all available and relevant information at all times.
Producing greater returns through active management is not possible if the investment market in question is efficient.
What is passive investment management?
Passive 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.
Advantages:
* Cheaper, by not paying for active skills, such as dealing and research
* Expected to be less volatile relative to the benchmark
Disadvantages:
* Limited upside potential
* Limited to asset classes where suitable benchmark exists
* Require the belief in efficient markets
What is tactical asset allocation?
Tactical asset allocation may be involved in an attempt to maximise return, which is a departure from the benchmark position and hence conflicts with the minimisation of risk. The size of the assets relative to the liabilities will determine the risk involved in such an action.
Thus, the investor may make short-term tactical deviations away from the long-term strategic asset allocation in order to take advantage of the temporary under- or over-pricing of particular assets.
List the factors to consider before making a tactical asset switch
- The expected extra returns relative to the extra risk taken.
- Constraints on the changes that can be made to the portfolio, e.g. due to regulation
- The expenses of making the switch
- The problems of switching a large portfolio of assets, e.g. price shifting
- 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.
In making the switch, there is a balance between selling the asset at a bad time and the switch taking a long time. A partial solution to gain exposure immediately is through derivatives.
Discuss the term “risk budgeting”
The term risk budgeting refers to the process of establishing how much risk should be taken and where it is 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 total fund active risk and strategic risk
2. allocating the total fund 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 tolerance of the stakeholders in the fund.
Strategic risk
The risk of poor performance of the strategic benchmark relative to the value of the liabilities
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
Active risk
The risk of underperformance if the fund managers do not invest exactly in line with the individual benchmarks as they are given
What are the key determinants deciding how much strategic and active risk to take?
The key question on strategic risk is the risk tolerance of the stakeholders in the fund. This is the systematic risk they are prepared to take on in an 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
- Liability structure may have changed significantly
- The funding level of a scheme or free asset position may have changed significantly, 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 tracking error:
The most usual measure adopted is the retrospective or backwards-looking tracking error - the annualised standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance. - Forward-looking tracking error:
The equivalent prospective measure is the forward-looking tracking error - an estimate of the standard deviation of returns that the portfolio might experience in the future if its current structure were to remain unaltered.
List other investment risks, outlining how each might be measured
- Strategic asset allocation risk - can be measured using the forward and backward looking approaches as above, assuming that the relevant parts of the portfolio were invested in the appropriate benchmark indices, and the effects of the actual strategic allocation compared with the target allocation.
- Duration risk - can be measured using forward or backward looking tracking error approaches
- Counterparty, interest rate and equity market risk - can be 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, which can be assessed using similar techniques.
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 different in fund value could be sought from the manager.
List the 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-weigthed rate of return (MWRR) is identical in concept to an internal rate of return - it is the discount rate at which the present fvalue 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 is ignored.
What is the main limitation of the MWRR?
The MWRR factors in all cashflows, including contributions and withdrawals. Assuming 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 (after the client deposits more funds) the manager has a short period of underperformance, the MWRR measure may not treat the manager fairly over the whole period.
Define TWRR
The time-weighted rate of return (TWRR) is the preferred industry standard as it is not sensitive to contributions or withdrawals.
Deposits and withdrawals are usually outside the manager’s control; thus a better performance measurement tool is needed to judge a manager fairly and allow for comparisons with peers - a measurement tool that will isolate the investment actions, and not penalise for deposit / withdrawal activity.
Again, the cashflows in the formula for calculating the TWRR only include those relating to new money. Any cashflows generated by the fund itself must be taken into account in the figures for the fund value.
Dividend income can be assumed to be reinvested, or not, as required.
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.
Explain why it can be difficult to assess the investment performance of a CIS
Collective investment schemes have a daily (sometimes less frequent) pricing point.
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 publicly on a continuous basis.
