C16 Investment Management

Question 1

What is meant by the term ‘active management’

Answer 1

• 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

Question 2

What is meant by the term ‘passive management’

Answer 2

• 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

Question 3

What is ‘tactical asset allocation’

Factors to consider before making a tactical asset swtich

Answer 3

• 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

Question 4

Define the term ‘risk budgeting’

Describe the risk budgeting process

Answer 4

‘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:
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)

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

Question 5

Define strategic, structural and active risk

Answer 5

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

Question 6

How to determine how much strategic and active risk can be taken?

Answer 6

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

Question 7

Discuss the two conflicting objectives faced by investment fund managers

Answer 7

Managers will often face two conflicting objectives
1. Enhance security
a. Cautious approach
b. assets chosen follow the benchmark or target

2. Achieve high long term investment return
   a. Encourages a move away from the benchmark
   b. Assets with higher expected return
   c. Higher associated risk

Question 8

Three reasons to review the continued appropriateness of an investment strategy

Answer 8

Reasons to review the continued appropriateness of an investment strategy:
Liability structure may have changed significantly (new class of business, mergers, benefit improvement or legislation)
Funding or free asset position may have changed significantly
Manager’s performance may be significantly lower than that of other funds