Ch17: Investment management Flashcards
Investment management Intro
- Have modelled assets and liabilities (to get SAA), now consider how to implement strategy
- Degree to which strategy is implemented depends on risk appetite using a process called risk budgeting
Two ways SAA can be implemented actively
- Could deviate from the modelled SAA and follow a Tactical Asset Allocation strategy (TAA)
- Could decide to use active rather than passive managers for the underlying asset classes
Passive investment management description
- Holding of assets that closely reflect that of a underlying index or benchmark
- Belief in efficient markets - prices accurately reflect all availabke information at all times i.e. impossible to generate excess risk adjusted returns by using an active approach
- Manager has little freedom to choose investments
- Cheaper, less volatile, less upside potential
- Limited to asset classes where suitable index exists
Active investment management description
- Invloves actively seeking out under or over priced asstes which could be traded to enhance returns (sectors or individual assets)
- Involves short term tactical deviations away from benchmark strategy
- Assumes markets are inefficient
- Additional returns could be offset by extra costs of more regular transactions
- Risk of judgement error
- Manager has few restrictions on the choice of investments
Two levels at which to decide between active vs passive
- Asset allocation (say 10% equity, 40% property …)
- Stock selection level (within an asset class)
Objective of passive manager
- Track or replicate the performance of an index as closely as possible in an efficient manner
- Minimise tracking error
Tactical asset allocation description
- Short term deviations away from SAA in pursuit of higher returns
- SAA represents ,long-term status quo while TAA is short-term and is only done when markets present opportunities to generate higher returns
Factors to be considered before implementing TAA (6)
- Level of free assets
- Expected additional returns to be made relative to the additional risk
- Constraints on the changes that can be made to the portfolio
- Expenses of making the switch
- Problems of switching a large portfolio of assets
* such as shifting market prices
* Timimg issues - Difficulty of carrying out the switch at a good time
* Dealing costs
* Tax liability arising if capital gain is crystalised
Risk budgeting description and process
- Process of establishing how much risk should be taken and where it is most efficient to take on the risk in order to maximise return
- For investment risks; two parts:
* Allocate max permitted overall risk between total fund active risk (manager risk) and strategic risk (TAA risk)
* Allocating total fund active risk across component portfolios - Diversification plays a key role - Total risk is reduced when targeting low correlation assets
Strategic, active and structural risk
Strategic risk:
* Risk of poor performance of SAA vs modelled matched benchmark (SAA selection at start plus shorterm TAA)
* Risk of poor perfromance of modelled matched benchmark vs liabilities
Active risk:
Managers deviation from their given benchmark
Structural risk:
Mismatch between aggregate of portfolio benchmarks and total fund benchmark (rebalancing time delays + parcticalities)
Why necessary to review appropriateness of any investment strategy at regular intervals (3)
- Liability structure may have changed significantly (following writing of new class of business, takeover, benefit improvements, legislation)
- Funding or free asset position may have changed significantly
- Manager’s performance may be significantly out of line of that of other funds
Three things to monitor in investment management
- Performance of whole portfolio relative to SAA benchmark
- Perfromance of asset managers relative to their benchmarks
- How much active risk each manager took on
Duration risk
- A portfolio that needs to closely match assets with liabilities will have a target and acceptable range for duration of fixed interest element
- Otherwise investments may be:
* Too long for liabilities (liquidity risk)
* Too short for liabilities (reinvestment risk)
Two measures of performance
Money-weighted rate of return:
* Anagolous to IRR
* Rate of return for which PV of inflows = PV of outflows in portfolio
* Takes into account actual cashflows and timing - results are impacted by cashflows
* Any cashflows generated by fund itself are ignored
* Advantages:
* Good for measuring absolute returns from portfolio
* Disadvantages:
* Not good for comparing performance - influenced by size and timing of cashflows (out of manager’s control)
Time-weighted rate of return:
* Measures compounded growth rate of an investment
* Eliminates eddect of cash inflows and outflows
* Calculates return foe each sub-period and linking them geometrically
* Advantage:
* Better for comparing results
* Disadvantages:
* Not that practical (too much data required)
Two measures for measuaring passive risk
Historical tracking error:
* Measures how closely the portfolio follows the index
* Measured as the standard deviation of the difference between the portfolio and index returns
Forward-looking tracking error
* 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 unchanged
