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

Tracking errors and the index performing poorly.

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 advantages of risk budgetting

Answer 10

1. It bases asset allocation not purely on the asset’s expected return - but also on its contribution to the portfolio.
2. It increases the attention paid to low correlation investments - Allocations to such investmets can reduce the total risk of the portfolio thorugh diversification

Question 11

What are the conflicting objectives of portfolio construction?

Answer 11

1. Ensuring security.

2. Achieving high long-term returns.

Question 12

Define: Strategic risk.

Answer 12

The risk that the strategic benchmark does not match liabilities.

Question 13

Define: Active risk.

Answer 13

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

The risk of poor performance from the fund manager relative to the benchmark

Question 14

Define: Structural risk.

Answer 14

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

Question 15

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

Answer 15

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 16

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

Answer 16

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

Question 17

Define: Historic tracking error.

Answer 17

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

Question 18

Define: Forward-looking tracking error.

Answer 18

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

Question 19

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

Answer 19

Measuring strategic risk.

Question 20

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

Answer 20

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

Question 21

Give an important consideration when analysing investment risks.

Answer 21

Allowance should be made for the benefits of diversification.

Question 22

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

Answer 22

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

Question 23

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

Answer 23

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

Question 24

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

Answer 24

MWRR and TWRR.

Question 25

Define MWRR and give a shortfall of using this method.

Answer 25

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 26

Define TWRR and give an advantage.

Answer 26

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 27

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

Answer 27

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 28

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

Answer 28

Structural risk
Active risk
Strategic risk