Approaches to Investment - CH9

Question 1

What are the 3 approaches to Investment?

Answer 1

• ESG
• Passive
• Active

Question 2

What is ESG Investing?

Answer 2

The level to which environmental, social and governance factors are considered when investing.

Question 3

What is Traditional ESG?

Answer 3

Avoiding sin stocks, e.g. alcohol and weapons, altogether.

Question 4

What is the issue with Traditional ESG investing?

Answer 4

The investor has no ability to create change in the industry - solution is activist investing.

Question 5

What is Activist Investing?

Answer 5

Investing in a company and using your stake to influence and get the company to do ‘less bad’.

Question 6

UN: Kofi Annan did what?

Answer 6

Created 6 responsible principles. Led to establishment of PRI.

Question 7

What is the PRI?

Answer 7

Non-profit org that engages policy makers and investors to invest more sustainably.

Question 8

What did the FSB do?

Answer 8

created the Task Force for Climate-related Financial Disclosures (TCPD) - after G20 asked what they could do about climate-related investing.

Question 9

What 4 areas does TCFD focus on?

Answer 9

1) Governance disclosure.
2) Strategy disclosure.
3) Risk management disclosure.
4) Metrics and target disclosure.

Question 10

What is Spectrum Investing?

Answer 10

Focuses on 5 levels of ESG:
1) Fully delegated, light touch - rely on managers ESG policies.
2) Ethical / Values based - avoid controversial sectors.
3) Integrated approach - managed ESG risk to seek positive ESG outcomes.
4) Impact investing - invest in companies that provide a solution + market returns.
5) Impact only - invest in solutions but no market returns (philanthropy).

Question 11

Pros of ESG investing?

Answer 11

• Better returns.
• Lower risk - esp in periods of market volatility.
• Best reflects the changing attitudes of investors.

Question 12

Cons of ESG investing?

Answer 12

• Ethics cloud judgement - may miss opportunities of greater profits.
• More research required.
• Greenwashing - companies claiming to be ESG to get funding but they’re not.

Question 13

What is Passive management?

Answer 13

Following a benchmarked index. Not trying to outperform the market to get better returns.

Question 14

What are the pros of passive management?

Answer 14

• Performance of the fund is not linked to manager’s ability to make investment choices.
• Investors only exposed to the systemic risks of the market (good too because majority of actively managed portfolios don’t outperform the index).
• Less fees for investors compared to actively managed portfolios.
• Lower expense ratios than actively managed funds (e.g. hedge funds).
• Innovative investment products (e.g. smart beta ETFs).

Question 15

What are the cons of passive management?

Answer 15

• Investors must be satisfied by index returns - can’t be changed.
• Investors should accept returns of fund will be close to the returns of the index (acceptable relative returns but not absolute).
• Lack of control, especially if markets become volatile.
• No alpha generated (above market returns).
• Certain markets don’t have facilities to track markets (e.g Africa and Asia).

Question 16

Why might investors choose not to invest in Passively managed funds?

Answer 16

Not satisfied by EMH - some market segments may generate better returns, thus invest in these:
- Greater beta stocks (more likely to return above market gains or losses).
- Stocks less correlated to the market (e.g. gold).

Question 17

What is Beta?

Answer 17

Sensitivity of an investments movement in relation to the overall market.

Question 18

What does market beta equal?

Answer 18

Beta = 1

Question 19

Fund beta > 1 equals?

Answer 19

Fund is more volatile than the market.

Question 20

Fund beta < 1 equals?

Answer 20

Fund is less volatile than the market.

Question 21

What issue does smart beta aim to address?

Answer 21

Tracking market cap weighted index goes overweight in stocks that are ovrvalued, and underweight in stocks that are undervalued.

Question 22

What does Smart Beta do?

Answer 22

Uses an alternate system that combines over performance (active) with lower costs (passive).

Question 23

What are the 2 types of funds that use this smart beta concept?

Answer 23

1) Hedge fund replication.
2) Factor investing.

Question 24

When are Passive Bond Strategies employed?

Answer 24

When the market is efficient (buy and hold) or when the bond portfolio is constructed around meeting a future liability fixed in nominal terms.

Question 25

What is the passive management technique?

Answer 25

Immunisation (employed by a bond manager with a known future liability).

Question 26

What is an Immunised bond?

Answer 26

One that is insulated from the effects of changing future interest rates.

Question 27

How are immunised bonds performed?

Answer 27

• Cash matching.
• Duration-based immunisation.

Question 28

What is Cash matching?

Answer 28

Constructing a bond portfolio whose coupon and redemption payments are synchronised to match those of liabilities to be met.

Question 29

What is Duration-based immunisation?

Answer 29

Constructed bond portfolio with the same initial value as the present value of the liability it’s designed to meet, and the same duration (Bullet portfolio).

Question 30

What other portfolio strategies are their other than a Bullet portfolio?

Answer 30

• Barbel - if bullet duration is 10yr, barbel may be 5 and 15 yr. Thus needs to be rebalanced more frequently.
• Ladder - equal amounts invested in bonds with diff durations - e.g. liability with 10yr, a ladder strat could be to hold equal amounts in bonds with a 1yr, 2yr, etc.

Question 31

What does EMH assume?

Answer 31

That it’s impossible to beat the market because the market is so efficient it prices in all relevant info.

Question 32

According to EMH, what is the only way to generate greater returns than the market?

Answer 32

By purchasing higher risk stocks, because stocks always trade at their fair value, thus is impossible to purchase undervalued stocks or sell over-inflated ones.

Question 33

What does it mean if EMH is correct?

Answer 33

Means that active investing is pointless and that passive investing is more beneficial and cheaper.

Question 34

What is Active investing?

Answer 34

Investment strategy where fund manager’s goal is to outperform a selected index (rarely outperforms).

Question 35

What is the one advantage of active investing?

Answer 35

Allows for a selection of investments, not just the market.

Question 36

Why is this an advantage?

Answer 36

• Investors may be skeptical of EMH - some market segments may be more efficient than others.
• Reduced volatility by hedging.
• Able to take on greater risk (by purchasing stocks with a beta > 1).
• May want to avoid investing in certain industries.

Question 37

What are the cons of active investing?

Answer 37

• Bad fund manager = bad performance.
• More costly than passive.
• Higher transaction costs diminish the fund’s returns (short-term capital gains).
• More specialised funds available to investors that are cheaper (Smart beta ETFs).
• When the funds get too big, they take on index-linked characteristics (broad selection of securities - becomes a pseudo-tracker of an index + fees).

Question 38

What is meant by a manager having ‘skin in the game’?

Answer 38

Fund manager has a stake in the fund, thus has a vested interest in it’s success. This aligns managers interests with stakeholders.

Question 39

Who use active bond strategies?

Answer 39

Bond managers who don’t think the bond market is perfectly efficient, thus subject to mispricing. Thus try to capitalise on the mispricing.

Question 40

What does bond switching aim to do?

Answer 40

outperform buy and hold by exchanging bonds perceived to be overpriced with those perceived to be underpriced.

Question 41

3 forms of bond switching?

Answer 41

• Anomaly switching.
• Policy switching.
• inter-market spread switch.