5. Role of the Investment Manager

Question 1

A. Investment management process (page 2)

Answer 1

Broken down into FOUR STAGES:

1. Determining client’s investment objectives
2. Formulating investment policies/strategies to meet those objectives
3. Stock / fund selection
4. Performance measurement

Question 2

A1. Modern portfolio theory (pages 2 & 3)

Answer 2

• before MPT, portfolios lacked diversification
• MPT suggests a systematic procedure for evaluating different combinations of securities and
• selecting combinations that provide the optimal reward for a given level of risk

The optimal combinations lie on the ‘efficient frontier’

• using quantitative techniques and diversification reduces risk
• however, SYSTEMATIC or market risk cannot be completely solves through diversification
• however, NON-SYSTEMATIC or investment-specific risk can be reduced or even eliminated

Question 3

A2. Asset allocation (pages 3, 4 & 5)

Answer 3

• some research suggests that asset allocation acounts for 90% of total portfolio returns, where as others suggests it is more like 60%
• to appreciate risk and return and diversification it is important to appreciate long-term performance of the different asset classes
• 1980-1999: equities and bonds performed very well
• 2000-2010: one of the worst decades for equities
• 2013-2019: recovery of equities

Question 4

A2. Asset allocation (pages 3, 4 & 5) - BEWARE OF HIDDEN FLUCTUATIONS

Answer 4

• it is important to look at the volatility of the investments of time, as although overall performance may have been good, the volatility may have been equally as high

Question 5

A2. Asset allocation (pages 3, 4 & 5)

CONTINUED

Answer 5

Common areas that most asset allocation exercises consider:

1. Timescale
2. Acceptable level of loss
3. Need for income

There are two steps in asset allocation:

1. Deciding the benchmark for the portfolio
2. Making active investment decisions around the benchmark (referred to as dynamic or tactical asset allocation)

Question 6

A2A. Optimisation models (pages 7, 8 & 9)

Answer 6

Optimisation models can generate optimal portfolios on a risk/return basis that make up the efficient frontier

• Efficient frontier is the set of portfolios that offers the maximum rate of return for any given level of risk

To run optimisation models three sets of data are needed:

1. Returns of each asset class
2. Standard deviations or risk of each asset class
3. Correlations between each pair of asset classes

Question 7

A2A. Optimisation models (pages 7, 8 & 9) - CORRELATION

CONTINUED

Answer 7

• Correlation of 1.0 implies a positive relationship
• Correlation of -1.0 implies the opposite

Imperfect correlation (negative correlation) could reduce risk via diversification

• correlation can get worse in bad times as more asset classes move closer together

High correlation implies:

• similar economic structures and business cycles
• similar industry weightings
• listings of shares on more than one country’s exchange

Question 8

A2A. Optimisation models (pages 7, 8 & 9) - PROBLEMS WITH OPTIMISATION MODELS

CONTINUED

Answer 8

• forecasts for risk, return and correlation may be incorrect
• historical data may be a poor indicator of the future
• correlation in extreme conditions very different from the norm
• appropriate measure of risk assumed to be standard deviation based on normal distributions
• transaction costs not taken into consideration
• beta not equal to one applies

Question 9

A2B. Stochastic modelling (page 9)

Answer 9

Stochastic modelling applies a mathematical technique to generate a probabilistic assessment of returns and volatility.

It does this by specifiying a number of factors each within a determind range.

Thousands of outcomes are then plotted and the most common one taken as the most likely path in respect of returns and volatility.

Usually results are plotted with the central band as the likely outcome and other bands spreading outwards showing less likely outcomes.

Question 10

A2C. Benchmarks (pages 9 & 10)

Answer 10

Benchamarks should be:

• aligned to risk adopted by the investment manager
• be specified in advance
• be appropriate to the manager’s investment style
• be unambiguous in construction
• be accepted by the investment manager
• be investable (possible to replicate the benchmark)

Purpose of the benchmark:

• set down the neutral, long-term position of the portfolio
• evaluate the investment performance of the manager

Question 11

A2C. Benchmarks (pages 10 & 11) - PRIVATE INVESTOR INDICES

Answer 11

For discretionary investment managers a common custom benchmark is the Private Investor Indices (PII) provided by MSCI.

• PI Conservative Index
• PI Income Index
• PI Balanced Index
• PI Growth Index
• PI Global Growth Index

Question 12

A2C. Benchmarks (page 11) - PENSION FUNDS

Answer 12

Pension funds (i.e. DC and DB schemes) now have a lower weighting of equities and a higher weighting of fixed interest.

This is because over the longer term (20 years) equities have performed poorly in comparison to bonds.

Cost of providing DB pensions has risen do managers are taking less risk (i.e. using less equities).

Question 13

B. Portfolio Construction (page 11)

Answer 13

Once the client’s aims and goals have been determined it is important to develop an investment strategy which will implement these and also determine portfolio construction.

Question 14

B1. Reducing risk through diversification (page 12)

Answer 14

• reduces the risk of any one particular investment
• spreads the opportunity for potential return across asset classes
• minimises the risk of the whole portfolio suffering a significant downturn
• increases the possibility of stable returns through all economic cycles

Question 15

B2. Applying asset allocation to portfolio construction (pages 12 & 13)

Answer 15

• diversification is essentially defensive
• if you want all out growth then being offensive and concentrating assets needs to be carried out
• asset allocation generally has a much greater impact on performance than the selection of fund managers
• firms will have a selection of portfolios with different asset allocations to meet the different levels of investor risk and providing the most return for the least risk (for that investor risk level)

Question 16

B3. Diversification within a portfolio (page 13)

Answer 16

• Asset allocation is not the only way to apply diversification; so is stock selection within an asset class

Question 17

B3A. Diversification across asset classes (page 13)

Answer 17

At the highest level, diversification across the main accset classes is looked at first

Question 18

B3B. Equity diversification (pages 13 & 14)

Answer 18

Equity diversification should be across:

1. Individual shares (not holding one share reduces the risk of a single share collapsing and causing issues)
2. Sectors (holding bank and government shares for example offers more diversification)
3. International markets (different market perform in different ways and at different times)

Question 19

B3C. Bond diversification (page 14)

Answer 19

Bond diversification should be across:

1. Issuer type (government and corporate bonds)
2. Credit Rating (mix of high and low)
3. Sectors (using multiple sectors)
4. International (using sterling and foreign bonds)

Question 20

B3D. Commercial property diversification (page 14)

Answer 20

Commercial property diversification should be across:

1. The three sectors of RETAIL, OFFICE and INDUSTRIAL
2. Have a geographical spread across the UK
3. Maybe invest internationally too where possible

Question 21

B3E. Diversification using eollective investments (page 15)

Answer 21

• for smaller investors, diversification is usually best acheived through using collectives either actively or passively managed
• professional management within collective funds can reduce risk via the information they hold and skills that individuals investors do not have

Question 22

B4. Model portfolios (pages 16 & 17)

Answer 22

There are no universal guidlines for model portfolios, however there are some common threads:

• more aggressive an investor is the more they hold in equities
• shorter time horizon equals a lower equity element
• greater the requirement for income, the higher the proportion assigned to fixed interest funds
• main weighting in each sector is likely be towards UK assets
• diversification is important for all portfolios and at all levels
• property is important because of its low correlation with other assets

Where firms create/manage their own portfolios they need to:

• establish a process for fund research, selection and monitoring
• the portfolios need to be reviewed regularly
• they may need to be revised at regular intervals

Question 23

B4. Model portfolios (pages 16 & 17)

Answer 23

Ignoring underlying asset allocation can have problems:

WITH-PROFITS FUNDS:

• these held 60% in equities in the 2000s, but now hold closer to 40%
• Were these ever offering ‘smoothed’ returns?

MANAGED/BALANCED FUNDS:
- because of ABI share restrictions (i.e. 20-60%), these have less potential problems as the % that can be held in equties has been clearly defined

Question 24

B5. Choice of tax wrappers (pages 17 & 18)

Answer 24

• the choice of tax wrappers should come after the risk-profiling and asset allocation selections
• so investments should be chosen on the basis of expected risk/return characteristics and therefore independent of tax treatment

Question 25

C. Portfolio management (page 18)

Answer 25

- once a portfolio has been set up it will need to be reviewed and modifications made to the original asset allocation - STRATEGIC ASSET ALLOCATION: is the long-term asset allocation decision - TACTICAL ASSET ALLOCATION: is the temporary or ad-hoc changes made by the manager

Question 26

C1. Strategic asset allocation (pages 18 & 19)

Answer 26

- this is where the manager decides what proportion of the portfolio to invest in the major asset classes The manager will then also consider: DIVERSIFICATION - combining different asset classes to decrease risk - diversification need to be targeted within asset classes as well as between asset classes LIQUIDITY AND ACCESSIBILITY - an actively managed portfolio will need an element of liquidity to make purchases when necessary - important for accessibility of investments where necessary INVESTMENT HORIZON - time horizon will affect if an investor has the resources to follow through with a long-term strategy - short-term liabilities should be matched by short-term investments

Question 27

C1. Strategic asset allocation (pages 18 & 19) - REBALANCING

Answer 27

- rebalancing should be carried out when needed and not be an automatic thing - research shows that rebalancing more than every 6 months does not achieve better results

Question 28

C1. Strategic asset allocation (pages 18 & 19)

Answer 28

Most practitioners focus on strategic asset allocation for two main reasons: 1. if the adviser is happy that they have specified the client's risk tolerance and requirements then, in theory, there is an asset allocation to which the portfolio wil conform 2. modern portfolio theory says that it is not possible to 'time the market' which means that switches between asset classes are more likely to incur loss than profit

Question 29

C2. Tactical asset allocation (pages 19 & 20)

Answer 29

- Sometimes known as 'MARKET TIMING' - Is the short-term variation of asset allocation to take advantage of market changes - It is the movement away from the strategic asset allocations detailed by the manager BULL - investor and market are positive about events - expecting the market or share to rise BEAR - investor and market are negative - expecting the market or share to fall

Question 30

C2. Tactical asset allocation (pages 19 & 20) - CONTINUED

Answer 30

Based on market outlool, tactical asset allocation might result in some of the following strategies: FIXED INCOME - bullish view would result in a move toward being weightier in longer duration bonds - a bearish view would mean moving away from longer duration bonds to shorter duration bonds EQUITIES - bullish view would result in picking stocks with a higher beta - bearish would be holding less higher beta stocks - buoyant markets could mean holding more emerging markets stocks - bearish would mean moving to a 'risk-off' position and holding less equities DERIVATIVES - Bullish view - buy call options or go long by buying stocks futures - Bearish view - buy put options or go short by buying stocks futures

Question 31

C2. Tactical asset allocation (pages 19 & 20) - CONTINUED

Answer 31

Tactical Asset Allocation methods: | - used more by DFMs than managers operating on an advisory basis

Question 32

D. Investment management styles (pages 20 & 21)

Answer 32

Two styles: ACTIVE (attempting to outperform the market) and PASSIVE (not attempting to outperform the market)

Question 33

D1. Active investment management (page 21)

Answer 33

- aim is to outperform the benchmark against which it is set - uses fundamental, technical and macroeconomic analysis to identify future trends and pick stocks ADVANTAGES - informed investment decisions based on experience - possibility of higher returns than the benchmark - ability to take defensive measures in a downturn DISADVANTAGES - higher fees and operating expenses - market, sector and stock analysis may fail and the fund may underperform - investment style adopted may fail

Question 34

D2. Passive investment management (pages 21 & 22)

Answer 34

- make no use of research to build a portfolio - asset allocation matches that of the index ADVANTAGES - low costs - returns in line with an index - no reliance on manager performance or ability DISADVANTAGES - performance dictated by an index - in a downturn the portfolio will decline with the index - index fund managers not able to move out of sectors or stocks about to decline

Question 35

D3. Core-satellite strategies (pages 22 & 23)

Answer 35

- mixture of active and passive investing - 70-80% of funds are passive - with an active element known as satellites - the opposite words too, with a core of active funds (using value-investing) and a satellite of passives

Question 36

E. Client reporting (page 23)

Answer 36

- basis and frequency of the reporting are detailed in the client agreement - investment manager should report on the performance of the portfolio verses the benchmark

Question 37

Chapter 5 Key Points (page 24)

Answer 37

INVESTMENT MANAGEMENT PROCESS - determining a client's investment objectives - formatting the investment policy and strategy to meet those objectives - stock / fund selection - performance measurements PORTFOLIO THEORY - MPT says that risk and returns cannot be seen in isolation so must be viewed together and may result in diversifying risk away - optimisation models generate optimal portfolio that fit along the efficient frontier - correlation can be used to estimate the degree of diversification being achieved PORTFOLIO CONSTRUCTION - largest part if a return from a portfolio comes from asset allocation selection (being in the right asset classes) PORTFOLIO MANAGEMENT - now that we have the client's objectives identified, we can develop an investment strategy to implement these - will determine how the portfolio will be built within the client's risk tolerance and capacity for loss - asset allocation methodology is essentially defensive INVESTMENT MANAGEMENT STYLES - active or passive - long-term selection is strategic - short-term / ad-hoc changes are tactical CLIENT REPORTING - need to compare the performance of the portfolio with a suitable benchmark - basis and frequency of the reporting are detailed in the client agreement