Ch 17: Investment management Flashcards
Active investment management
Active management is when the manager has few restrictions on the choice of investments, perhaps just a broad benchmark of asset classes.
This enables the manager to make judgements as to the future performance of individual investments, in both the long and short term.
Passive investment management
Passive management is the holding of assets that closely reflect those underlying a certain index or specific benchmark. The manager therefore has little freedom to choose investments.
Passive investment management:
+ cheaper
+ expected to be less volatile
- limited upside potential
- limited to asset classes there suitable benchmark exists
- require belief in efficient markets
List 6 factors to consider before making a tactical asset switch
1) The expected extra (lower) returns relative to the extra (lower) risk taken
2) Constraints on the changes that can be made to the portfolio, e.g. due to regulation
3) The expenses of making the switch, e.g. dealing expenses
4) The problems of switching a large portfolio of assets, e.g. price shifting
5) Tax implications
6) The difficulty of carrying out the switch at a god time
The ability to absorb the extra risk is also relevant. Partial solution to gain exposure immediately through derivatives
Define the term ‘risk budgeting’
The process of establishing how much risk should be taken and where it is the most efficient to take the risk (in order to maximise return)
The risk budgeting process has 2 parts:
1) Deciding how to allocate the maximum permitted overall risk between active risk and strategic risk.
2) Allocating the total active risk budget across the component portfolios
Risk budgeting is, therefore, an investment style where asset allocations are based on an asset’s risk contribution to the portfolio as well as on the asset’s expected return
Overall risk = strategic risk + active risk + structural risk
Risk tolerance is the main influence on SAA
Strategic risk
The risk of poor performance of the strategic benchmark relative to the value of the liabilities
Structural risk
The risk of underperformance if the sum of the individual benchmarks given to fund managers does not add up to the strategic benchmark
Active risk
The risk of underperformance if the fund managers do not invest exactly in line with the individual benchmarks as they were given.
What are the key determinants deciding how much:
- strategic risk
- active risk
to take?
The key question is the risk tolerance of the stakeholders in the fund. This is the systematic risk they are prepared to take on in the attempt to increase long term returns.
Another big question on active risk is whether it is believed that active management generates positive excess returns.
What are the 2 conflicting objectives faced by an investment fund established to cover liabilities?
1) To ensure security, i.e. to meet liabilities
2) To achieve high long term investment returns
Give 3 reasons why a provider’s investment strategy should be regularly monitored
1) Liabilities change over time
2) The funding level of a scheme or free asset position of a company changes over time, affecting the level of matching required
3) Monitoring helps identify whether the fund manager’s performance is in line with that of other funds.
Outline the considerations when setting investment performance objectives
- An investment fund should only be compared against similar funds with similar objectives and restrictions on the manager, not directly to the generality of funds.
- One of the best benchmarks to use is the return that would have been achieved by an index fund, which had maintained the asset allocation proportions set in the fund manager’s benchmark
- It is important to note any other constraints on the manager, e.g. a shortage of cashflow or the timing of cash inflows and disinvestments
Define 2 measures of active risk
(tactical asset allocation = active risk)
1) Historic (or backward looking) tracking error, i.e. annualized standard deviation of difference between actual and benchmark returns (used for equity portfolios).
2) Forward-looking tracking error, i.e. estimated standard deviation of relative returns in the current portfolio was unaltered
List other investment risks, outlining how each might be measured
1) Strategic asset allocation risk
- measured using forward or backward looking tracking error approaches, comparing strategic allocation with target (liability-matched) allocation.
2) Duration risk
- measured using forward or backward looking tracking error approaches
3) Counterparty risk
- interest rate and equity market risk-measured as the amount of capital that has to be held against that particular risk, possibly relative to that required for a target portfolio.
Allowance should be made for the benefits of diversification across risks.
Describe a simple method for measuring the performance of a fund manager against their allocated benchmark, including areas where care needs to be taken.
Input all cashflows int and out of the fund to a spreadsheet that also holds the daily values of the benchmark.
Calculate the value of the fund over a chosen period on the basis that it had been invested in the benchmark rather than in the actual assets held, and compare this with the actual fund value achieved.
Care needs to be taken in relation to:
- The treatment of income, and in particular, whether the benchmark index includes reinvestment of income or is capital only, taking into account whether the manager is assessed on capital or total investment performance
- The allowance for fees
A decision is needed on how frequently performance is monitored.
An analysis of reasons for the difference in fund value could be sought by the manager.
List 2 methods of measuring the rate of return on an investment portfolio
1) Money weighted rate of return (MWRR)
2) Time weighted rate of return (TWRR)
