5. Role of the Investment Manager Flashcards
A. Investment management process (page 2)
Broken down into FOUR STAGES:
- Determining client’s investment objectives
- Formulating investment policies/strategies to meet those objectives
- Stock / fund selection
- Performance measurement
A1. Modern portfolio theory (pages 2 & 3)
- 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
A2. Asset allocation (pages 3, 4 & 5)
- 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
A2. Asset allocation (pages 3, 4 & 5) - BEWARE OF HIDDEN FLUCTUATIONS
- 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
A2. Asset allocation (pages 3, 4 & 5)
CONTINUED
Common areas that most asset allocation exercises consider:
- Timescale
- Acceptable level of loss
- Need for income
There are two steps in asset allocation:
- Deciding the benchmark for the portfolio
- Making active investment decisions around the benchmark (referred to as dynamic or tactical asset allocation)
A2A. Optimisation models (pages 7, 8 & 9)
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:
- Returns of each asset class
- Standard deviations or risk of each asset class
- Correlations between each pair of asset classes
A2A. Optimisation models (pages 7, 8 & 9) - CORRELATION
CONTINUED
- 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
A2A. Optimisation models (pages 7, 8 & 9) - PROBLEMS WITH OPTIMISATION MODELS
CONTINUED
- 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
A2B. Stochastic modelling (page 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.
A2C. Benchmarks (pages 9 & 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
A2C. Benchmarks (pages 10 & 11) - PRIVATE INVESTOR INDICES
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
A2C. Benchmarks (page 11) - PENSION FUNDS
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).
B. Portfolio Construction (page 11)
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.
B1. Reducing risk through diversification (page 12)
- 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
B2. Applying asset allocation to portfolio construction (pages 12 & 13)
- 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)
B3. Diversification within a portfolio (page 13)
- Asset allocation is not the only way to apply diversification; so is stock selection within an asset class
B3A. Diversification across asset classes (page 13)
At the highest level, diversification across the main accset classes is looked at first
B3B. Equity diversification (pages 13 & 14)
Equity diversification should be across:
- Individual shares (not holding one share reduces the risk of a single share collapsing and causing issues)
- Sectors (holding bank and government shares for example offers more diversification)
- International markets (different market perform in different ways and at different times)
B3C. Bond diversification (page 14)
Bond diversification should be across:
- Issuer type (government and corporate bonds)
- Credit Rating (mix of high and low)
- Sectors (using multiple sectors)
- International (using sterling and foreign bonds)
B3D. Commercial property diversification (page 14)
Commercial property diversification should be across:
- The three sectors of RETAIL, OFFICE and INDUSTRIAL
- Have a geographical spread across the UK
- Maybe invest internationally too where possible
B3E. Diversification using eollective investments (page 15)
- 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
B4. Model portfolios (pages 16 & 17)
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
B4. Model portfolios (pages 16 & 17)
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
B5. Choice of tax wrappers (pages 17 & 18)
- 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
C. Portfolio management (page 18)
- 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
C1. Strategic asset allocation (pages 18 & 19)
- 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
C1. Strategic asset allocation (pages 18 & 19) - REBALANCING
- 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
C1. Strategic asset allocation (pages 18 & 19)
Most practitioners focus on strategic asset allocation for two main reasons:
- 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
- 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
C2. Tactical asset allocation (pages 19 & 20)
- 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
C2. Tactical asset allocation (pages 19 & 20) - CONTINUED
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
C2. Tactical asset allocation (pages 19 & 20) - CONTINUED
Tactical Asset Allocation methods:
- used more by DFMs than managers operating on an advisory basis
D. Investment management styles (pages 20 & 21)
Two styles:
ACTIVE (attempting to outperform the market)
and
PASSIVE (not attempting to outperform the market)
D1. Active investment management (page 21)
- 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
D2. Passive investment management (pages 21 & 22)
- 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
D3. Core-satellite strategies (pages 22 & 23)
- 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
E. Client reporting (page 23)
- 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
Chapter 5 Key Points (page 24)
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
