C16 Investment Management Flashcards
What is meant by the term ‘active management’
- Where manager has few restrictions on the choice of investments, perhaps just a broad benchmark of asset classes
- Enables manager to make judgements as to future performance of individual investments, in both long and short term
- Expected to produce greater returns (unless the market is efficient) but it carries greater risk and involves extra dealing costs
Active management could achieve higher returns by identifying:
- under- or over-priced sectors (e.g. banks or oil companies), to make sector selection profits
- individual stocks that are under- or over-priced, to make stock selection profits.
What is meant by the term ‘passive management’
- Holding assets that closely reflect those underlying a certain index or specific benchmark.
- Manager has little freedom to choose investments
- Not risk-free as index may perform badly or there may be tracking errors
What is ‘tactical asset allocation’
Factors to consider before making a tactical asset swtich
- Short-term deviation from long-term strategy (benchmark position) , in an attempt to maximise returns
Factors to consider:
1. Expected extra returns relative to extra risk taken
2. Ability to absorb extra risk i.e. the level of free assets
3. Constraints on the ability to make switch e.g. regulation
4. Expenses of making switch e.g. dealing expenses
5. Problems of switching a large portfolio of assets e.g. price shifting
6. Tax – crystallising capital gains
7. The difficulty of carrying out the switch at a good time (use derivatives)
Define the term ‘Risk budgeting’
Describe the risk budgeting process
‘Risk budgeting’: Refers to the process of establishing how much risk should be taken and where it is most efficient to take the risk (in order to maximise return)
Process for investment risks:
1. Deciding how to allocate the maximum permitted overall risk between active risk, structural risk and strategic risk
1. Allocating the active risk budget across the component portfolios (e.g. to UK equity manager, to UK bond manager)
Risk Budgeting: An investment style where asset allocations are based on an asset’s risk contribution to the portfolio as well as on the assets’ expected return
Features or benefits of Risk Budgeting Strategy
Risk Budgeting Strategy
1. Can free the manager to look for alternate investment to maximise returns
2. Total risk of the portfolio must stay at or below targeted level
3. Increased attention is paid to low correlation assets (lower risk through diversification)
Define strategic, structural and active risk
Strategic Risk – risk of underperformance if strategic benchmark does not match liabilities
Structural Risk – risk of underperformance if the sum of the individual benchmarks given to fund managers does not add up to the strategic benchmark
Active risk – risk of underperforming if the fund managers do not invest exactly in line with the individual benchmarks that they are given
How to determine how much strategic and active risk can be taken?
Determining how much strategic and active risk to take:
Key question on strategic risk is the risk tolerance of the stakeholders in the fund. This is the systemic risk they are prepared to take on in the attempt to enhance long-term returns
Key question on active risk is whether it is believed that active management generates positive excess returns
Discuss the two conflicting objectives faced by investment fund managers
Managers will often face two conflicting objectives
1. Enhance security
a. Cautious approach
b. assets chosen follow the benchmark or target
- Achieve high long term investment return
a. Encourages a move away from the benchmark
b. Assets with higher expected return
c. Higher associated risk
Three reasons to review the continued appropriateness of an investment strategy
Reasons to review the continued appropriateness of an investment strategy:
1. Liability structure may have changed significantly (new class of business, mergers, benefit improvement or legislation)
2. Funding or free asset position may have changed significantly
3. Manager’s performance may be significantly lower than that of other funds
Performance target return, comparison and constraints
Performance target return, comparison and constraints
- Returns judged relative that achieved by other managers for similar funds
- Performance targets are less appropriate for managers with severe restrictions on assets/asset classes.
- A better comparison is an index fund, which had maintained benchmark allocation
- Shortage of CFs will restrict fund available for investment or disinvestment at depressed value
List measures of different investment risks
Measuring different investment risks
1. Tactical Asset allocation risk
a. Historic tracking error
b. Forward looking tracking error
2. Strategic Asset allocation risk
3. Duration Risk
4. Counterparty, interest rate and equity market risk
5. Diversification benefits
Define Tactical asset allocation risk or Active risk
Tactical asset allocation risk or Active risk is the risk of following an active investment strategy rather than tracking the benchmark index.
Measuring active risk:
1. Historic tracking error : the annualised standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance.
2. Forward looking tracking error: an estimate of
the standard deviation of returns (relative to the benchmark) that the portfolio might
experience in the future if its current structure were to remain unaltered.
How to measure Historic Tracking Error
What are the problems with this measure
Historic Tracking Error: Annualised standard deviation of difference between actual and benchmark returns.
Problems:
1. Historic so will not necessarily reflect future risk
2. Result depends on timescale used, frequency of results and weightings attached to time periods
3. Most investors only interested in downside risk. tracking error considers both upside and downside risk
How to measure forward-looking Tracking Error
What are the problems with this measure
Fwd looking tracking error: Estimated standard deviation of relative returns if current portfolio was unaltered
Problems:
Not easy to calculate estimates for future volatility of individual assets and correlation between assets/markets.
How to measure Strategic asset allocation risk
What are the problems with this measure
Strategic asset allocation risk: Deviation in proportion the stock constitutes of actual portfolio relative to benchmark portfolio.
Problems:
1. Two stocks could have same active position but different volatility of returns
2. A departure in holding of one stock from benchmark may have a much greater impact on the overall return than an identical departure in holding of another stock.
So not a complete measure of risk.
Describe the current simplest way of comparing the actual performance of a fund against its benchmark
The simplest way of comparing the actual performance of a fund against its benchmark is to
- input all the cashflows that went into or out of the fund onto a spreadsheet that also holds the daily values of the benchmark.
- calculate the value of the fund over a period if it had been invested in the benchmark rather than in the actual assets held.
Care needs to be taken over the treatment of income; in particular whether a benchmark index includes reinvestment of income.
- If the index includes income reinvested, then dividends and interest on the actual portfolio are excluded as cashflows (but included in valuing the new end-period value of assets).
- If the benchmark is capital only then the actual income from the assets held needs to be included as cashflows.
The approach used will depend on whether the manager is assessed on capital or total investment performance.
The comparison must also allow for fees.
Explain why the frequency of performance measurement is important
- Regular enough to achieve the company’s objectives, to be confident that it can monitor performance, but mindful of the expense of monitoring too frequently.
- Most investment mandates are designed for medium- to long-term performance, so care must be taken not to overstate the impact in the very short term of market fluctuations.
- An analysis of reasons for departures from the benchmark performance could be sought
from the manager.
Performance of an overall investment strategy may also be monitored relative to a liability
benchmark.
Describe Money-weighted rate of return (MWRR)
Money-weighted rate of return (MWRR)
MWRR is the discount rate at which the present value of inflows = present value of outflows in a portfolio.
The formula places a greater weight on performance when the fund size is highest. Deposits and withdrawals are often outside a manager’s control, therefore a fairer measure may be time-weighted rate of return.
Describe Time-weighted rate of return (TWRR)
Time-weighted rate of return (TWRR)
TWRR is defined as the compounded growth rate of 1 over the period being measured. No account is taken of flows of money into or out of the portfolio.
This is the same basis on which benchmark indices are calculated. TWRR will not identify managers with skill at managing only funds of a particular size.
Collective investment schemes
Collective investment schemes
Usually priced daily or less frequently. Intra-day movements in certain markets can be material. Need to capture benchmark indices at same time of day.
