Chapter 17 - Investment Management Flashcards
(20 cards)
Active Investment management
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 as to the future performance of individual investments, in both the long term and the short term.
Active management may be expected to produce greater returns (unless the market is efficient) but it carries greater risk (of judgement being wrong) and involves extra dealing costs.
Tactical asset allocation
Short-term departure for the benchmark position in persuit of higher returns
An attempt to maximise return which is a departure from the benchmark position and hence conflicts with minimisation of risk. The size of the assets relative to liabilities will determine the risk involved in such an action
Passive investment management
The holding of assets that closely reflect those underlying a certain index or specific benchmark. The manager therefore has little freedom to choose invesments.
List 6 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, e.g. dealing expenses
The problems of switching a large portfolio of assets, e.g. price shifting
Tax implications
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.
Define the term “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 risk and strategic risk
2. Allocating the total active risk budget across the component portfolios
Risk budgeting is therefore an invesment style where ASSET ALLOCATIONS are based on asset’s risk contribution to the portfolio as well as on the asset’s expected return.
Strategic risk
The risk of poor performance of the strategic benchmark relative to the value of the liabilities
Active risk
The risk taken by the individual investment manager relative to the given benchmarks
Structural risk
Where the aggregrate of the individual investment manager benchmarks does not equal the total benchmark for the fund
What are the key determinants deciding how much:
-strategic risk
-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 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 two 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
The liability structure may have changed significantly
The funding or free asset position may have changed significantyl
The managets’s performance may be significantly out of 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 benchmark 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
List other investment risks, outlining how each might be measured (besides active asset allocation risk)
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 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.
Define 2 measures of active risk
(tactical asset allocation risk = active risk)
Historic (or backward-looking) tracking error, i.e. annualized 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.
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 ot 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 icome 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)
Define MWRR
The MWRR is the discount rate at which present value of inflows = present value of outflows in the portfolio
Define TWRR
The TWRR is the compounded growth rate of a unit investment over the period being measured. It is the product of growth factors between consecutive cashflows.
What is the main disadvantage of MWRR
The main disadvantage of the MWRR is that it places a greater weight on the performance in periods when the portfolio size is largest.
Therefore, if a manager outperforms the benchmark for a long period when the fund is small, and then (after the client puts more money into the fund) the manager has a short period of under-performance, the MWRR may not treat the manager fairly over the whole period. This is particularly an issue since deposits into and withdrawals out of the fund are not usually within the manager’s control.
Explain why it can be difficult to assess the investment performance if a CIS?
In order to make a fair assessment of the investment performance of a CIS manager, it is necessary to compare actual scheme performance with the benchmark at the same point in time.
CISs have a daily, sometimes less frequent, pricing point which is commonly noon or 3pm and is rarely at market close. However, published market indices are normally quoted at close of business.
In some markets, price movements can be significant between the CIS pricing point and the benchmark index point, and not all indices are available publicly on the continuous basis.
Hence, achieving comparison at the same point might be difficult.
