17 - Investment Management

Question 1

Define: Active investment management.

Answer 1

The investment manager has a few restrictions on investment choice within a broad remit.

Question 2

Define: Passive investment management.

Answer 2

Involves holding assets closely reflecting those underlying an index or specified benchmark. The investment manager has little freedom of choice.

Question 3

Give the main risks of active management.

Answer 3

Extra dealing costs and poor judgement.

Question 4

Give the main risks of passive management.

Answer 4

Index performs poorly
Underperformance due to dealing costs and tracking errors
Forego upside potential

Question 5

Define: Tactical asset allocation.

Answer 5

Involves short-term departure from the benchmark position in pursuit of higher returns.

Question 6

Give the factors to consider before making a tactical asset switch.

Answer 6

1. The expected extra returns compared with additional risk.
2. Constraints on changing the portfolio.
3. The expenses of making the switch.
4. Issues with switching large amounts of assets.
5. Taxes that may be realised during the switch.
6. Transaction delays in the market.

Question 7

Describe the principles of ‘Risk Budgeting’.

Answer 7

A process that establishes how much risk should be taken and where it is most efficient to take the risk in order to maximise returns.

Question 8

Why is direct comparison between actively and passively managed funds not advisable?

Answer 8

You would need to take the different constraints on the investment managers into account.
Survivor-ship of actively managed funds.
Differences in objectives of the funds.

Question 9

Give the aims of risk budgeting with regards to investment risk.

Answer 9

1. Deciding how to allocate the maximum permitted overall risk between active risk and strategic risk.
2. Allocating the active risk budget across the component portfolios.

Question 10

What are the conflicting objectives of portfolio construction?

Answer 10

1. Ensuring security.

2. Achieving high long-term returns.

Question 11

Define: Strategic risk.

Answer 11

The risk that the strategic benchmark does not match liabilities.

Question 12

Define: Active risk.

Answer 12

The risk taken by the individual investment managers relative to the given benchmarks.

Question 13

Define: Structural risk.

Answer 13

This is where the aggregate of the individual investment manager benchmarks does not equal the total benchmark for the fund.

Question 14

Why is it necessary to review the appropriateness of an investment strategy at regular intervals?

Answer 14

1. The liability structure may have changed significantly.
2. The funding or free asset position may have changed significantly.
3. The manager’s performance may be significantly out of line with that of other funds.

Question 15

What could be a significant inhibitor to an investment manager that should not influence their performance rating?

Answer 15

Constraints outside of the manager’s control, such as cash flow shortages within the provider.

Question 16

Define: Historic tracking error.

Answer 16

The annualised standard deviation of the difference between actual fund performance and benchmark performance.

Question 17

Define: Forward-looking tracking error.

Answer 17

Involves modelling the future experience of the fund based on its current holdings and the likely future volatility and correlations to other holdings.

Question 18

What do we use historic tracking error and forward-looking tracking error for?

Answer 18

Measuring strategic risk.

Question 19

Give an alternative used for quantify risks that are difficult to apply the other tracking errors to.

Answer 19

A proxy of the amount of capital required to be held against the risk such as under Solvency II or SAM.

Question 20

Give an important consideration when analysing investment risks.

Answer 20

Allowance should be made for the benefits of diversification.

Question 21

What is the simplest method of analysing investment performance against a benchmark?

Answer 21

To input all cash flows into and out of a fund into a spreadsheet that also holds the daily values of the benchmark.

Question 22

Give two important considerations when analysing investment performance against a benchmark?

Answer 22

The treatment of income by the benchmark and how frequently to monitor, keeping objectives in mind and the cost of monitoring.

Question 23

Give two common methods of analysing investment performance of fund managers.

Answer 23

MWRR and TWRR.

Question 24

Define MWRR and give a shortfall of using this method.

Answer 24

The interest rate that satisfies: PV(inflows) = PV(outflows).
Places a greater weight on performance when the fund size is greatest, which is out of a manager’s control and so it is not useful for comparing across managers.

Question 25

Define TWRR and give an advantage.

Answer 25

The compound growth rate of 1 over the period being measured.
This is the same basis used by benchmark indices and is the most useful for comparing across managers. However, does not indicate a manager’s skill at managing small vs large funds.

Question 26

Give an important consideration when analysing collective investment scheme performance against a benchmark fund .

Answer 26

Intra-day movements in certain markets can be material and the benchmark indices should be captured at the same time of day as the scheme performance.

Question 27

Break down the term ‘Investment Risk’ into the different risk components.

Answer 27

Structural risk
Active risk
Strategic risk