CH16 - Investment management Flashcards
Active investment management
Where the investment manager has a few restrictions on investment choice within a broad remit, perhaps just a broad benchmark of asset classes.
This enables the manager the make judgments regarding the future performance of individual investments, both in the long term and the short term.
It is expected to produce greater returns despite extra dealing costs and risks of poor judgment.
Passive investment management
Involves holding assets closely reflecting those underlying an index or specified benchmark. The investment manager has little freedom of choice. There remains the risk of tracking errors and the index performing poorly.
Tactical asset allocation (6)
Tactical asset allocation involves a short-term departure from the benchmark position in pursuit of higher returns. Before making a tactical switch consider:
- The expected extra returns compared with additional risk.
- Any constraints on changing the portfolio
- The expenses of making the switch
- Any problems of switching a large amount of assets (such as shifting markets)
- The tax liability arising if a capital gain is crystallised
- The difficulty of carrying out the switch at a good time
Risk budgeting (2)
Risk budgeting is a process that establishes how much risk should be taken and where it is most efficient to take the risk in order to maximise return.
With regard to investment risks, the risk budgeting process has two parts:
1. Deciding how to allocate the maximum permitted overall risk between active risk and strategic risk
i.e. how much risk in total the individual fund managers are allowed to take in order to out-perform their allocated benchmarks and how far to depart from the theoretically matched benchmark.
2. Allocating the active risk budget across the component portfolios.
e.g. how much risk the UK equity manager can take, the UK bond manager can take etc.
Risk budgeting is 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.
Portfolio construction objectives (2)
Portfolios are typically constructed to meet two (often conflicting) objectives of:
- ensuring security
- achieving high long-term returns
The first objective encourages a cautious approach, where the assets chosen follow the benchmark or target, while the second encourages a move away from the benchmark into assets that are expected to generate higher returns, although with a higher associated risk.
Quantifying risk (3)
The process of quantifying risk often involves diving risk into:
- strategic risk - the risk that the strategic benchmark does not match the liabilities
- active risk - the risk taken by the individual investment mangers relative to the given benchmarks
- structural risk - where the aggregate of the individual investment manager benchmarks does not equal the total benchmark for the fund.
The overall risk is the ‘sum’ of the active, strategic and structural risks.
Reasons for monitoring investment performance and strategy (3)
It is necessary to review the continued appropriateness of any investment strategy at regular intervals because:
- the liability structure may have changed significantly (for example, following the writing of a new class of business, a takeover, benefit improvements or legislation)
- the funding of free asset position* may have changed significantly
- the manager’s performance may be significantly out of line with that of other funds.
- Funding position is terminology that is most commonly used when referring to a defined benefit scheme. When referring to an insurer it is more usual to refer to the free assets or surplus or the solvency position.
Historic tracking error
The annualised standard deviation of the difference between actual fund performance and benchmark performance, based on observes relative performance.
This is the most usual measure adopted and also called retrospective or backwards-looking tracking error.
This is generally the standard deviation of the difference between two returns, not the standard deviation of returns.
Forward-looking tracking error
Involves modelling the future experience of the fund based on its current holdings and likely future volatility and correlations to other holdings.
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. This measure is derived by quantitative modelling techniques.
Money-weighted rate of return (MWRR)
It 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.
Identical in concept to an internal rate of return.
Time-weighted rate of return (TWRR)
It 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.
TWRR is the preferred industry standard as it is not sensitive to contributions or withdrawals.
Collective investment schemes
Usually priced daily or less frequently. Intra-day movements in certain markets can be material. Need to capture benchmark indices at the same time of day.
Tactical asset allocation risk
It is the risk of following an active investment strategy rather than tracking the benchmark index.
Strategic asset allocation risk
Where an overall portfolio is managed by a single manager, the manager will normally be given a target range of asset allocation as a percentage of the fund. For example: equities 40% to 60%, government bonds 10% to 50%, corporate bonds 20% to 50%, cash 0% to 25%. A target asset allocation which may not always be the centre point of the individual ranges will also be provided.
A strategic asset allocation risk can be measured using the forward and backward looking approaches as above, assuming that the relevant parts of the portfolio were invested in the appropriate benchmark indices, and the effects of the actual strategic allocation compared with the target allocation.
Duration risk
A portfolio that needs to closely match assets with liabilities will also have a target and an acceptable range for the duration of the fixed interest element.
