Ch 21 - Portfolio Management (2)

Question 1

Managers will often face a conflict between:

Answer 1

Reducing risk (by matching)

Enhancing investment returns (by mismatching)

Question 2

The investment policy therefore needs to reflect the extent to which the risks of lower stability and security are to be taken on in order to aim for higher returns.

This will typically involve a two-stage process:

Answer 2

Establishing the investment strategy (i.e. The strategic benchmark)

The tactical implementation of this strategy by the selection of one or more managers and a decision on the appropriate level of risk that these managers should take relative to the strategic benchmark

Question 3

The risks involved in portfolio construction may include:

Answer 3

Strategic risk
Active risk
Structural risk
Overall risk

Question 4

Strategic risk

Answer 4

Risk of the strategic benchmark relative to the liabilities

i.e. Strategic benchmark vs the bested matched position for liabilities

Extent of this risk will depend on risk appetite and available funds

Question 5

Active risk

Answer 5

Risk taken by the manager relative to his given benchmark

Measured by standard deviation of the active (or relative) return or by tracking error

Question 6

Active return

Answer 6

Return relative to his particular given strategic benchmark

Question 7

Structural risk

Answer 7

Where the aggregate of the individual manager benchmarks does not equal the total benchmark for the fund

Small funds are more exposed to this risk

Question 8

Multifactor models can be used:

Answer 8

Actively

To estimate the appropriate required return on a share in order to determine if it is cheap or dear

Passively

To identify a suitable portfolio of shares to match liabilities or to replicate an index (via sampling)

Question 9

Practical Problems with multifactor models

Answer 9

Identifying the factors that affect the expected return on any particular security

Estimating the relationships between those factors and the expected returns. The usual problems associated with time series estimation will all apply here:
Random variation
The fact that the relationships may change over time

Question 10

Quantitative Analysis

Answer 10

Use of modern mathematical techniques to aid stock and sector select

Question 11

Technical Analysis

Answer 11

attempt to predict future price (and/or yield) movements from the study of actual price (and/or yield) history and trading volume.

Based on investor psychology, such as behavioural finance and the view that history will repeat itself.

It relies on markets being inefficient.

Question 12

3 main forms of TA are:

Answer 12

Chartism
Mechanical trading rules
Relative strength analysis

Question 13

Chartism

Answer 13

Examining the charts of past market data (try to identify patterns or trends in the behaviour of a chart of a share price or market index)

Question 14

Mechanical trading rules

Answer 14

Whereby trading signals are given by set price movements

Subjective element of Chartism is removed here

Question 15

Relative strength analysis

Answer 15

Examines the performance of a share relative to the market as a whole or its own sub-sector

Two approaches:
Mean reversion
Momentum

Question 16

Advantages of TA

Answer 16

Easy to collect the necessary data

Relatively quick and easy to carry out

Can be helpful with decisions on the timing of investment

If you find a technique that works reliably, TA can be used to make short-term profits (and can leverage to get bigger gains)

Question 17

Disadvantages of TA

Answer 17

Distract the investor’s attention from more important considerations such as long-term value

Hefty losses

More active trading strategy, thus increasing expense levels

Subjective

Identify the pattern before any other chartist (thus, competition between chartists will compete the patterns away)

Question 18

Risk budgeting

Answer 18

Process of establishing how much investment risk should be taken and where it is most efficient (which areas of the portfolio) to take the risk (in order to maximise return).

It involves:

Deciding how to allocate the maximum permitted overall risk to total fund active risk and strategic risk

Allocating the total fund active risk budget across component portfolios

Question 19

Problems with comparing active vs index funds

Answer 19

Different objectives of active and passive managers

Different constraints

Higher risk amount in active managers’ portfolios

Survivorship bias

Past performance does not indicate future performance

Question 20

In practice, the following steps are involved in risk budgeting:

Answer 20

Set, Optimise, Monitor, Rebalance

Define a feasible set of asset classes

Choose an initial asset allocation using a risk/return optimisation process and a VaR assessment to determine risk tolerance

Monitor risk exposures and changes in volatilities and correlations

Rebalance the portfolio when necessary due to changes in risk appetite or changes in underlying short-term conditional volatility and correlation data

Question 21

Historical tracking error:

Answer 21

Annualised standard deviation of the difference between portfolio return and benchmark return (relative return)

Question 22

Must make sure the data is consistent when comparing the tracking error of two funds relative to an index

Answer 22

Timescale

Number of sub-periods

Weightings attaching to each period

Question 23

Forward-looking tracking error

Answer 23

Annualised standard deviation of relative returns that the portfolio might experience in the future if its current structure were to remain unaltered

Question 24

Active money

Answer 24

Difference between the portfolio holding and the benchmark holding in that share (in percentage)

Thus one measure to measure portfolio active risk might be to simply sum the absolute values of the active money positions in each individual holding (however, does not account for things like beta )

Question 25

Information Ratio:

Answer 25

Mean(relative return) / std dev(relative return)

Question 26

Uses of the Information Ratio

Answer 26

Allow us to estimate how efficiently additional risk can be converted into additional return, as part of the risk budgeting process

Show that they can out-perform the benchmark (either due to skill or by investing in higher risk securities)

Estimate prospective information ratios for different portfolio choices

Question 27

Strategic risk (calculation)

Answer 27

Standard deviation of relative returns (actual returns on strategic benchmark vs returns on matching portfolio)

Question 28

VaR

Answer 28

Potential losses on a portfolio

Over a given future time period

With a given degree of confidence

Can be measured in absolute terms or relative to a benchmark

Frequently assumes a normal distribution of returns

Question 29

Stress testing

Answer 29

This involves subjecting a portfolio to extreme market moves by radically changing the underlying portfolio assumptions and characteristics, in order to gain insight into portfolio sensitivities to predefined risk factors. This pertains in particular to asset correlations and volatilities

Two types of stress test:

1. To identify “weak areas” in the portfolio and investigate the effects of localised stress situations by looking at the effect of different combinations of correlations and volatilities
2. To gauge the impact of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are “stressed”

Question 30

Custodian

Answer 30

Holds investments securely on behalf of an investor.

They are usually banks or other regulated institutions.

Question 31

Services custodians offer:

Answer 31

CLIFTS

Cash management

Stocks lending

Income collection

Foreign exchange

Tax recovery

Security settlement

+ also exercise voting rights on behalf of the manager or trustees