17. Investment management

Question 1

Tactical asset allocation

Answer 1

• Involves short-term switching of investments in attempt to maximise returns
• May be done to exploit temporary over/underpricing of assets

Question 2

Factors to consider before switching assets

Answer 2

1. Expected extra returns relative to additional risk (if any)
2. Constraints
3. Expenses
4. Problems with switching large portfolio
5. Capital gains tax liability
6. Timing

Question 3

Risk budgeting

Answer 3

Process of establishing how much risk should be taken and where its most efficient to take risk and maximise returns

Question 4

Risk budgeting process

Answer 4

1. Decide how to allocate maximum permitted overall risk between total fund active risk and strategic risk
2. Allocate total fund active risk across component portfolio

• Key focus: systematic risk stakeholders are willing to take to enhance long-term returns

Question 5

Conflicting objectives in portoflio construction

Answer 5

1. Ensuring security

2. Achieving high long-term investment returns

Question 6

Portfolio construction and mismatching

Answer 6

1. Establish a strategic benchmark
   
   • Select appropriate asset mix accounting for nature of liabilities and representations about structure/asset made to investors
2. Select manager and decide on level of risk they can take relevant to benchmark

Question 7

Risks in portfolio construction

Answer 7

1. Strategy/policy risk- poor performance of strategic benchmark relative to value of liabilities
2. Active risk
3. Structural risk- risk of mismatch between aggregate of portfolio benchmarks and total fund benchmark
4. Overall risk= 1+2+3

Question 8

Importance of reviewing investment strategy

Answer 8

1. Liabilities may have changed significantly e.g.
   
   • New business class
   • Takeover
   • Benefit improvements
   • Legislation
2. Funding position may have changed
3. Manager performance may be out of line with competitors

Question 9

Investment risk

Answer 9

1. Strategy/policy risk- poor performance of strategic benchmark relative to value of liabilities
2. Active risk
3. Structural risk- risk of mismatch between aggregate of portfolio benchmarks and total fund benchmark
4. Overall risk= 1+2+3
5. Duration risk

Question 10

Measuring investment risk

Answer 10

1. Historical tracking error
2. Forward-looking tracking error
3. Capital needed to hold against risk

Must account for diversification

Question 11

Historical tracking error

Answer 11

Annualised standard deviation of difference between portfolio and benchmark return based on observed relative performance

Question 12

Forward-looking error

Answer 12

• Equivalent prospective error to historical
• Estimate of standard deviation of returns (relative to benchmark) that portfolio might experience in the future if current structure doesn’t change
• Derived using quantitative modelling

Question 13

Using capital to measure risk

Answer 13

Can calculate capital needed for target portfolio and actual portfolio
Best suited for risks that are hard to quantify e.g. counterparty, interest rate risk and equity market risk

Question 14

Comparing fund and benchmark performance

Answer 14

• Input all cashflows into spreadsheet holding daily values of benchmark
• Then calculate comparative performance over time

Question 15

Treatment of income in calculating comparative performance

Answer 15

1. If index includes reinvested income
   
   • Dividends + interest excluded as cashflows
2. If benchmark is capital
   
   • Include actual income

Question 16

Considerations in calculating comparative performance

Answer 16

• Must allow for fees
• Frequency must be regular to achieve objectives
• Frequency vs costs thereof
• NB to not overstate impact in short term market fluctuations wrt medium to long-term investments

Question 17

Methods to calculate comparative performance

Answer 17

MWRR
- Discount rate at which NPV = 0

TWRR
- Compound growth rate over period being measured, not accounting for flows of money into/out of portfolio

Question 18

MWRR

Answer 18

• Interest, dividends and capital gains not included since MWRR measures fund growth
• Include cashflow wrt new money/disinvestment

Limitation
- Greater weight on performance in periods when account size is large

Question 19

TWRR

Answer 19

• Calculate growth factors reflecting change in fund values between consecutive cashflow …
  …. then multiply growth factors to find overall return through period

Advantage:

• Not sensitive to investment deposits and withdrawals
• Can compare peers without penalising deposit/withdrawal activity

Limitation:
- Will not identify manager who’s good at managing small funds and weak at managing larger ones

Question 20

MWRR vs TWRR

Answer 20

• Must understand consequences of each method
• Circumstances of the business
• Purpose of comparison

Question 21

Measuring performance of CISs

Answer 21

• Have daily (/less frequent) pricing point
• Pricing point: Time of day when values of underlying A in scheme are captured
• Usually noon/15:00 rarely at market close

•Published market indices are normally quoted at close of business
•Intra-day movements in some markets may be material&raquo_space;>
»> … fair to capture benchmark indices at same time as pricing point

•Some market indices not publicly available continuously