Chapter 11: Investment Strategy Flashcards
Describe the difference between the competitive part of investment strategy and the non-competitive part of investment strategy.
Competitive and non-competitive investment strategy
Both the competitive and the non-competitive parts of investment strategy tend to be included in the subjective or qualitative part of the job, rather than the objective and quantitative part of the job.
The non-competitive part involves using well-known and well-used techniques such as the capital asset pricing model to determine how much beta to accept in an investment strategy, and determining how much additional return this should theoretically bring.
The competitive part involves finding a different viewpoint or angle that is different from the herd, and using it to develop a strategy that will add value.
Investment strategy is often developed using a risk budgeting approach. Describe the key stages (four) of this process.
Risk budgeting process:
The first stage:
is knowing the details of the investor or the investing institution.
This might involve the liabilities (including the term, nature and currency of those liabilities), any other assets that exist or income that is expected, and any benchmarks or hurdles that need to be achieved.
The second stage:
involves determining the investor or institution’s risk appetite.
Generally the more risk that can be taken, the more return can be earned on the assets.
The third stage:
is determining where the risk should be taken to maximise returns.
This may involve strategic mismatching of the liabilities, or active alpha.
The final stage:
involves monitoring the outcome to ensure that risk factors have not changed and to ensure that the portfolio does not need adjusting.
Describe the role of the investment committee in a typical institutional investor.
Explain why the task of selecting investments is typically outsourced to specialists.
Investment committee:
The job of this committee is usually an oversight role, which may be described as the ‘governing fiduciary’ role.
It is usually composed of members from the trust board who have expertise in investments.
The committee looks after the tasks involved with designing an investment strategy, and deciding how to implement that strategy.
Outsourcing to specialists:
The selection of investments, or the ‘managing fiduciary’ role, is often handled by specialists because it requires special knowledge and skills to carry out the task.
Investment committees do not normally have these resources or skills in house.
Nor does the investment committee have the time to undertake this task.
The job of delegation and of ongoing monitoring is the responsibility of the investment committee.
Explain how investors’ risk appetites change during periods of calm and period of turmoil.
Risk appetites and the link to market turmoil:
In general it is observed that investors and institutions become risk seeking after long periods of calm markets.
This is probably due to the fact that the previous market turmoil has been forgotten, which may embolden the investors.
It may be amplified by the herd mentality of investors such that when one investor increases risk and achieves higher returns, then others follow.
During market turmoil there is a flight to quality, which usually results in investors selling risky assets after they have fallen in price.
This is termed a ‘buy high, sell low’ strategy and can have a negative impact on institutional returns.
The behaviour may be further amplified by the regulators’ actions.
If capital requirements are strengthened during market turmoil, this can force further selling of risky assets.
Finally if the investment decision-makers are not the clients that own the funds, then it is easier for the decision-makers to reverse a strategy at a loss.
Describe why the strategic asset allocation part of an investment strategy is not frequently reviewed, and state who’s responsibility this is.
Strategic asset allocation responsibility:
The decision is complex, and is one of the most important parts of the investment strategy (ie it will have a big influence on the success or failure of the strategy).
It takes time to design an asset allocation, and is often carried out with the help of experts such as actuarial investment consultants.
For these reasons the investment committee often retains control and responsibility, but does not frequently review the allocation.
Describe the two main ways that ethical issues such as environmental, social or governance (ESG) preferences can be introduced to the investment strategy.
Two main ways to introduce investment ESG into the strategy:
- by constraining the universe that the investment manager can select from when implementing the strategy (for example, banning companies that make weapons from the portfolio).
This can involve negative screening (avoiding companies that carry out an activity) or positive screening (actively buying companies that undertake certain activities deemed commendable). - by using the voting power of the asset portfolio to actively encourage companies to behave in a better way (for example, pressuring managers to avoid business in areas where workers may complain of poor workers’ rights, or where the government does not adhere to certain standards).
List five questions that should be considered when setting an ESG policy
Five questions (when setting ESG policy)
- What is the impact on the expected level of investment return?
- What are the risks associated with the policy?
- How will the policy be implemented?
- Does the policy have broad stakeholder acceptance?
- Is the policy properly documented?
Describe the following terms that are related to ESG policy:
* integration
* negative screening
* positive screening
* ESG-related indices
* thematic approach.
ESG terms (ESG policy)
Integration:
Integration is the introduction of the ESG policy into every part of the strategy process, from the company to whom the investment management is outsourced to, the actual managers that look after the day to day investment decisions, the voting policy of the fund, etc.
Positive screening:
Positive screening involves actively encouraging investment in companies that behave in a certain way or operate in a certain sector.
Negative screening:
Negative screening involves ruling out investments in certain sectors or companies that behave in certain other ways.
ESG-related indeces:
Using an ESG-related index can involve monitoring the performance of the fund relative to such an index. This will indirectly cause the manager to tilt the fund in this direction to avoid too much relative performance risk.
Thematic approach:
A thematic approach involves selecting equities or bonds based on themes such as ‘renewable energy’ or ‘education’. Green bonds are bonds where the proceeds have been used for green purposes.
Describe the following terms with regard to ESG:
* engagement
* policy advocacy
* stewardship
* ESG scores
- Engagement
Engagement is a process of dialogue between investors and company management whereby investors try to reshape the company’s activities to meet certain demands.
It can involve investor forums which allow shareholders to collaborate in powerful blocks (without breaching stock exchange rules), and can result in public denouncements or even legal action against the company. - Policy Advocacy:
policy advocacy is where investors engage in dialogue with many relevant parties, including regulators, industry bodies, and policymakers, in order to change the behaviour of companies in a more sustainable and environmentally friendly manner. - Stewardship:
stewardship is another term for ‘active ownership’ whereby investors use their voting power to influence decision-making. - ESG scores:
ESG scores are awarded to companies by specialist firms based on how the company’s business is affected by sustainability and environmental issues, and how the company is tackling these exposures.
The scores can be subjective, and different firms will view things in different ways.
List five factors that should be considered when setting assumptions for investment returns.
Five factors that should be considered when setting investment returns
- the projected investment horizon
- the date at which the assumptions are made
- the credit quality of the institution issuing the security
- the currency of the security
- the liquidity of the security.
There will be guidance on the process which will have been designed by local expert and regulatory bodies. This needs to be adhered to.
When using historical data to calibrate, design or set return assumptions for an asset model, describe the limitations caused by:
* regime change
* fluctuations in valuation
* random variation.
Regime change:
A belief that drives share price movements in one period (for example globalisation, ESG, bond versus equity) can change in subsequent periods. Using data from the previous period to predict returns in the current regime can be invalid.
Fluctuations in valuation:
Asset valuations can differ markedly from one decade to the next. Dividend yields might be 4% to 8% in the 80s, but be 2% to 4% in the 2000s. The lower income yield on investments in the 2000s inevitably means that future returns would be expected to be lower than previous returns.
Random variation:
Even when regimes are unchanged, and valuations are the same, the randomness of investment returns means that the past may be a poor guide to future returns.
List five factors that make it difficult to incorporate risk guidelines into an investment strategy.
Five factors that make it difficult to incorporate risk guidelines
- Risk is hard to define.
Many people use volatility of returns, but this may not be appropriate. - It is difficult to determine the appropriate extra return achieved for a certain level of risk (again without assuming CAPM).
- Institutions often have a variety of time horizons that they consider.
The risk appetite over each one may be different. - Most risk models use historical data to determine risk levels. These are often inappropriate for projecting future risk levels (although risk has been relatively stable over a long period).
- Normal distributions are often used to combine risks of various asset categories together. This may be inappropriate.
Describe three factors that make correlation between asset categories a particularly difficult parameter to use when modelling portfolio returns.
Three factors that make correlation difficult to use
- Historically correlation has been a volatile parameter; not simply that it moves from high to low, but that it moves from positive to negative.
- Correlation behaves very differently in a crisis than it does in calm markets.
The flight to quality behaviour often means that certain assets are sold and certain assets are purchased when investors are spooked (e.g. gold; gold ETFs). - Correlation has a big impact on the diversification of a portfolio and therefore on the resulting risk level.
Small changes in an assumption can make large differences in the outcome.
Outline the key features of the following indices:
* Russell 2000 and Russell 1000
* FTSE100
Russell 2000 and Russell 1000
The 2000 is the dominant US small-cap index.
It is designed to cover the 1001st largest stock to the 3000th largest stock.
The Russell 1000 consists of the 1000 largest stocks in the US market, which is inconsistent with the S&P500.
The inconsistency is generally overlooked except among US based institutional investors.
A large proportion of institutional investors use the Russell 1000 as a large cap index in preference to the S&P 500.
FTSE100
This is the best-known UK large-cap index and is used by the media and by institutional fund managers.
It is a market capitalisation weighted index of the 100 largest shares quoted on the UK market, and has a range of supporting indices such as dividend yield, XD, PE and total return indices.
Outline the key features of the following indices:
* Dow Jones
* S&P 500
Dow Jones (Dow Jones Industrial Average – DJIA)
It is the most widely quoted stock index in the US, consisting of Industrial companies only, which was launched in 1896.
The DJIA is a price-weighted or unweighted (not capitalisation-weighted) index of only 30 stocks, and hence is rarely used today as the basis for analytics or products.
S&P 500
This is the globally best-known capitalisation-weighted index of the US stock market.
It consists of 500 of the largest companies and covers around 80% of total capitalisation.
A large array of analytical tools and derivative instruments has been built from this index.
List the main problems that index providers have when constructing fixed interest market indices.
Main problems when constructing fixed interest indices
- Fixed interest bonds require to be sub-divided by credit rating rather than by issuer, because many bonds from different issuers are very alike, but credit ratings are subjective
- Different rating agencies will categorise bonds differently, so the selection of which ratings to use has a big impact on the resulting performance of the index
- One company may have several bonds with different features (eg secured/unsecured, option-embedded) and therefore different ratings
- Bonds of different terms have different ratings
- Many bonds are thinly traded, and therefore the price and the yield is difficult to determine accurately
- It is difficult to determine which bonds are traded sufficiently to include in an investible index
- Some indices can end up being dominated by one or two large issues.
List the three key high-level factors to decide on when designing a model to optimise the asset strategy for an institutional investor.
Three key high-level factors to decide on when optimising a strategy
- a model of the return characteristics of the investment strategies under consideration (which will be determined by the expected returns on each asset category, and the correlations between those categories)
- a model of the risk characteristics of the strategies under consideration (which will be determined by the volatility of each asset category and the correlations between them)
- a means of balancing the two (which might take the form of a formal utility function or some other expression of risk tolerance).
It should be noted that the difference in return between the optimal strategy and several other very different-looking sub-optimal strategies is often insignificant.
Describe the two main types of economic scenarios generator (ESG) used in asset models and in asset-liability models.
Two main types of ESG for models
- The first type is a ‘real world’ ESG, which generates realistic probabilities for market variables (such as inflation) reaching certain levels.
They are based on a certain starting point.
The Wilkie model from the 1970s is an early example of such a stochastic model, which incorporates mean reversion and a term structure for volatility.
Newer models can capture fat tails, skewed distributions of returns and ‘flight to quality’ effects that are observed in the real world. - The second type is a ‘risk-neutral’ or ‘market consistent’ model.
These are particularly useful to price options that are embedded in liabilities or in asset classes.
Often these models can be used alongside real-world models.
Outline eight problems that occur when trying to calibrate an economic scenario generator (ESG).
The key words in the eight problems (there are more than eight key words!) can be recalled using the first letter of each of the words in this sentence:
(# ‘Cold Calls Make Me Really Furious I Think, Newton Said’)
Eight problems that occur when trying to calibrate an ESG
(# ‘Cold Calls Make Me Really Furious I Think, Newton Said’)
- Ensuring the calibration produces sensible results at multiple time horizons (eg avoid very negative interest rates)
- Over what time periods should the correlation data be captured?
- The problems of capturing multiple markets, eg adding additional markets results in more interest rate curves to calibrate, which should all behave consistently.
- Older data may be of little relevance to current market conditions, but equally, an ESG should generate some simulations that correspond to a regime change from current market conditions.
- Incorporation of ‘fat tails’ for equities and ‘left-tailed’ risk distributions for credit losses.
- Choosing inconsistent time periods for different asset categories.
- Increasing the number of simulations and incorporating nested loops improves the stability at expense of computational speed.
- Also: Exponential weighting of time series data may lead to unnecessarily low volatility in current market conditions.
Summarise the risk budgeting process in four steps.
The risk budgeting process in four steps
- Define the ‘feasible set’ – the set of asset classes that could be included in the portfolio.
Here the risk budgeter will wish to obtain careful estimates of the volatilities and covariances of each asset class. - Choose the initial asset allocation using some risk / return optimisation process, and with a VaR assessment to determine the risk tolerance.
- Monitor risk exposures (increases and decreases in the values of the positions) and changes in volatilities and correlations.
- Rebalance the portfolio in response to changes in the short-term conditional volatility and correlations of the assets. Allocations are altered to keep the overall portfolio risk at the level defined as tolerable for the investor.
Describe the term ‘risk parity’ and discuss the drawbacks encountered when using it to develop an investment strategy.
Risk parity
Risk parity is a special case of risk budgeting where a portfolio is constructed such that equal contributions to overall risk are targeted across each of the components of the portfolio.
Drawbacks
This approach is arguably pro-cyclical. If equities rise, their volatility usually drops, so risk parity funds would buy more stocks.
If equities fall sharply or crash, volatility will spike, so risk parity funds will sell.
Furthermore, many such funds have relatively short-term measures of risk, eg the average of the last five years returns. These funds may only be taking into account a recent bull market and their narrative does not include any significant market corrections.
This exposes them to being substantially misallocated in the event of a change in market behaviour, due to changes in observed volatility or correlations.
