17. Investment management

Question 1

What is active investment management

4

Answer 1

• Manager has few restrictions on the choice of investments
  1. Broad benchmark of assets
• Enables the manager to make judgments regarding future (long- and short-term) performance of individual investments
• Expected to produce greater returns unless the market is efficient
• Greater risk and dealing costs

Question 2

What is passive investment management

Answer 2

• Holding assets that closely reflect those
• Underlying a certain index or specific benchmark
• Manager has little freedom to choose investments
• Risks:
  1. Tracking error or index performs badly

Question 3

What factors should be considered before making a tactical asset switch

Answer 3

DETECT

• Difficulty in carrying out the switch at a good time
• Expected extra return relative to extra risk taken
• Tax implications (on capital gains)
• Expenses of making the switch
• Constraints on changes that can be made to the portfolio (regulatory restrictions)
• Trouble of switching a large portfolio of assets (price shifting)
• Level of free assets

Question 4

What is risk budgeting

Answer 4

• Process of assessing how much risk should be taken and
• Where it is most efficient to take the risk to achieve maximum return
• Two components of the risk budgeting process:
  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 of portfolios
  => SA equity manager, SA bond manager
• Risk budgeting is an investment style where asset allocations are based on:
  1. The asset’s risk contribution to the portfolio
  2. The asset’s contribution to the expected overall return

Question 5

What is strategic risk

Answer 5

• Risk of underperformance if the strategic benchmark does not match liabilities

Question 6

What is structural risk

Answer 6

• Risk of underperformance if the sum of the individual benchmarks given to fund managers does not add up to the strategic benchmark

Question 7

What is active risk

Answer 7

• Risk of underperformance if the fund managers do not invest exactly in line with the individual benchmarks that they are given

Question 8

What are the key determinants of how much strategic and active risk to take?

Answer 8

• Strategic risk: Risk tolerance of the stakeholders
• Systematic risk that they are prepared to take in an attempt to enhance long-term returns
• Active risk: Whether the company believes that active management generates positive excess returns

Question 9

What are the conflicting objectives faced by an investment fund established to cover liabilities?

Answer 9

• Enhance security (low volatility)
• High long-term returns

Question 10

Reasons for monitoring investment strategy

Answer 10

• Liabilities change over time
• Funding level of a scheme or free asset position of a company changes over time
• Monitoring helps identify whether fund performance is in line with other funds/expected

Question 11

What are the considerations when setting investment performance objectives?

Answer 11

• An investment fund – compare against similar funds:
  1. Similar investment objectives
  2. Similar fund managers’ restrictions
• Return that would have been achieved by an index fund (maintained by the same asset allocation proportions set in the fund manager benchmark)
• Note any other constraints on the managers:
  1. Shortage of cash flow
  2. Timing of investment or disinvestment

Question 12

Methods of measuring active risk

Answer 12

• Tactical asset allocation risk is the risk of following an active investment strategy rather than tracking a benchmark index
• Historic (backward-looking) tracking error:
  1. Annualized standard deviation difference between actual and benchmark returns
• Forward-looking tracking error:
  2. Estimated standard deviation of relative returns if the current portfolio was unaltered

Question 13

What are the other investment risks?

Answer 13

• Strategic asset allocation risk:
  1. Measured using forward- or backward-looking tracking error approaches
  2. Comparing strategic allocation with target allocation
• Duration risk:
  1. Forward-looking or backward-looking tracking approach
• Counterparty, interest rate, and equity market risk:
  1. Amount of capital needed to be held against that particular risk
  2. Compared against the amount of capital required to be held for a target portfolio
• Allowances for benefits of diversification across risks should be made

Question 14

What are the two methods of measuring the rate of return on an investment portfolio?

Answer 14

1. Money-weighted rate of return (MWRR)
   * Discount rate at which PV (Inflow) = PV (Outflow)
   * Allows for all cash flows and their timing
2. Time-weighted rate of return (TWRR)
   * Compound growth rate
   * Unit of investment over the period being measured
   * Product of growth factors between consecutive cash flows
   * That is, between periods where there is no cash inflow or outflow from the fund

Question 15

What are the main disadvantages of MWRR and TWRR?

Answer 15

1. MWRR
   * Places greater weight on the performance when the portfolio size is largest
   * If a manager outperforms the benchmark for a long period when the fund is small, but after a large inflow has a short period of underperformance, the MWRR might not treat the fund manager fairly over the whole period
2. TWRR
   * Will not identify the manager who is skilled at managing small funds and weak at managing large funds, and vice versa
   * Large data requirement too
   *

Question 16

Why might it be difficult to assess the investment performance of a CIS manager?

Answer 16

• You need to compare the actual scheme performance with the benchmark at the same point in time
• CIS has daily pricing points (e.g., noon)
• Price of the index (benchmark) quoted at close
• In some markets, significant price movements can occur between pricing point and close
• Hence, achieving comparisons at the same time is difficult

Question 17

What is a simple model for measuring the performance of a fund manager against their allocated benchmark?

Answer 17

• Cash flows: Spreadsheet which holds the daily value of the benchmark
• Fund value: As if invested in the benchmark rather than actual assets
• Compare this with the actual fund value achieved
• Care needs to be taken regarding:
  1. Treatment of income (whether the benchmark includes reinvestment income or is capital-only)
  2. Allowance for fees
• Decide how frequently to monitor the performance
• An analysis of the difference can be sought from the managers