Chapter 12: Investment Management Flashcards
Describe the typical characteristics of ‘value’ stocks.
Characteristics of value stocks (Subjects SA7 & SP5)
The most important are that they have low PE ratios (or high ‘earnings yields’, where earnings yield is the earnings/price, and earnings are forecast where possible) and high dividend yields (Subject SP5).
They commonly have high ‘book values’ (the net asset value per share according to the company’s accounts) as a percentage of the market capitalisation (Subject SA7 and SP5).
They also have high cashflow yields (cashflow from operating activities divided by market capitalisation) (previous SP5 version).
Describe the typical characteristics of ‘growth’ stocks.
Typical characteristics of a growth stock (Subjects SA7 & SP5)
They will have experienced high historical earnings growth, and will have high forecast earnings growth, both over the short term and the long term.
Sales growth will also be high.
They have higher PE ratios and low dividend yields.
Describe the other styles used by portfolio managers (other than value and growth) for selecting between shares, which can lead to a style bias.
Style bias
Momentum:
Is a style whereby shares that are rising are purchased on the basis that they will continue to rise with the momentum that they have.
Contrarian:
is the opposite, whereby a share which has risen a certain amount is sold.
These are based on the price charts and behavioural issues rather than looking at accounting fundamentals and ratios (as is the case with value and growth).
Rotational:
is a style that rotates between value and growth.
Large/small cap:
Large cap and small cap are styles whereby the portfolio is more heavily weighted towards shares with large or small market capitalisation in the benchmark index.
Describe the two styles that can be used to construct a portfolio (rather than a style of selecting between different shares).
Styles of constructing a portfolio
Top-down:
Top-down is a method whereby decisions on asset allocation are made from the top and are then filtered down to the individual markets or individual sectors.
Once this is done, the shares are selected for those sectors (they might be selected on a value or growth basis, or some other stock selection style).
Bottom up:
Bottom up is a method whereby the shares are selected from the feasible set without considering how the funds should be split on a high level.
The aim is to maximise the stock picker’s freedom to select between shares without the restrictions imposed by a top-down allocation.
Outline the skills that are required (both financial and business skills) by the management team of an investment management company.
Skills required by the management team
HR:
People management: managing highly-skilled and highly-paid people, and coping with ‘ego’ risks.
Recruiting, retaining, rewarding and (importantly) motivating these people are key skills.
BD:
Business development strategies (including having the resources in place to cope with growth)
Marketing and new business skills
Client:
Client reporting and management skills
Legal/Reg:
Legal and compliance skills
Finance:
Financial management skills such as cashflow management, bank relationship management, capital management and shareholder relationships are also important as most companies are limited companies with their own share capital.
The funds that an investment manager manages can typically be split into two types.
Outline the two types of fund.
Two types of fund
- Retail funds.
Funds such as unit trusts, investment trusts, ETFs and OEICs that are run by the manager and marketed directly to the public and other investors. - Institutional funds.
These are typically the main asset pool that backs the policies sold by a life company, or of a pooled pension fund. Less common are assets owned by institutional investors such as charities or university endowment funds.
The split may not be clear cut, as some institutions offer unit trusts and investment trusts directly, but arrange for an external investment management company to manage the asset portfolio on their behalf.
Describe the following terms used to describe investment management companies:
* active
* passive
* active quantitative
* multi-asset
* specialist
Defining terms
Active:
Active managers aim to outperform a benchmark index by stock selection and sector allocation.
This can be done by stock selection skills (alpha) or taking more or less market risk (beta), or by fundamental analysis skills.
Passive:
Passive managers aim to track an index as closely as possible without involving expensive management skills and costs.
Active quantitative:
Active quantitative managers aim to design adaption of a standard index that, if passively tracked, should outperform the standard index.
It is similar to smart beta.
Fees will be higher than typical passive managers but lower than active.
Multi-asset:
Multi-asset managers will manage funds across all asset classes including property, overseas assets, hedge funds, private equity and derivatives.
Specialist:
Specialist managers are specialists in one or more asset classes and accept funds that aim to actively outperform standard indices in those sectors.
Describe responsibilities of the following teams or individuals that can be found in an investment management organisation:
* Chief investment officer (CIO)
* Execution team / dealing team
* Quants team
* Middle office
* Responsible investing team.
Responsibilities of individuals and teams
CIO:
overall head of investments and almost certainly a Board director
Execution team / dealing team:
responsible for executing the deals requested by portfolio managers for the various funds that the company manages.
These deals may be executed directly on dealing systems linked to the markets or through brokers or using dark pools.
Quants team:
using historical and accounting data to find new strategies that add performance or to back-test strategies suggested by portfolio managers.
For passive (and other) funds the quants team may take over the role of the portfolio manager.
Middle office:
responsible for risk management, control and reporting.
The risks considered include investment risks, but also operational risks such as settlement, IT, compliance and fraud.
Responsible investing team:
deals with ESG issues including engagement.
List four factors that should be considered when the middle office is assessing the level of operational risk in an organisation.
(# COMIC P)
Four factors that impact operational risk
(#COMIC P)
- the culture of the organisation
– the extent to which individuals are aiming at excellence in performance of their roles, and the extent to which they consider it necessary to go beyond just going through the motions - Manual Intervention
any reliance on manual intervention in any processes, without adequate checks and balances. - Character
the character and professionalism of the individuals involved - proportionality
– not expending a disproportionate degree of resources to generate spurious accuracy
Outline the six biggest challenges in today’s investment management marketplace.
Six biggest challenges today
- Reporting on inclusion and diversity issues
- Incorporating ESG and responsible investing into their portfolios
- Regulation increase:
this causes a significant increase in costs and makes it much more difficult to launch new products - Increasing choice, transparency and flexibility in the products available in the wealth management industry
- Recruiting and retaining staff and talent
- Finding new clients and retaining existing clients
State (from Subject SP5):
* the standard formula for calculating the money-weighted rate of return (MWRR)
* the main advantage and disadvantage of using it to assess the investment manager’s performance.
Money-weighted rate of return (MWRR)
(Subject SP5)
Formula:
VT = V0 * (1 + i)^T + sum (Ct * (1+ i)^(T-t)
Where:
V 0 , TV are market values of fund at beginning & end of period
C t is net cashflow into fund (excluding investment proceeds) at time t
i is money-weighted rate of return.
+ Represents actual rate of return earned by fund and so can be compared with actuarial assumptions.
– Depends on timing and amounts of net cashflows into fund. If these are outside the manager’s control, then it is unfair to compare performance based on MWRR against other managers.
State:
* a formula for the time-weighted rate of return (TWRR).
* the main advantage and two main disadvantages of the TWRR.
Time-weighted rate of return (TWRR)
(Subject SP5)
Formula: cf timing at start of period
(1+i)^T = Vt1/V0 * Vt2/(Vt1 + Ct1) * … * VT/ (Vtn + Ctn)
where:
V 0 , TV are market values of fund at beginning & end of period Ct r is net cash inflow, excluding investment proceeds, at time rt Vt r is market value of fund at time tr just before cashflow
i is time-weighted rate of return
+ Independent of timing and amounts of net cashflows into fund
– Requires knowledge of fund value at date of each cashflow
– Doesn’t give actual return on the capital and income invested
Explain how the linked internal rate of return (LIRR) is calculated.
List the circumstances under which it will give a close approximation to the TWRR.
Linked internal rate of return (LIRR) Calculated by:
1. determining fund value at various dates throughout year
2. calculating internal rate of return for each inter-valuation period
3. linking inter-valuation rates of return to get linked internal rate of return.
Gives close approximation to TWRR if:
* short inter-valuation periods are used, or
* valuations occur close to dates of cashflows, or
* cashflows are small relative to size of the fund, or
* rate of return is very stable over each inter-valuation period.
State the formulae for the four risk-adjusted performance measures.
Four risk-adjusted performance measures
- Treynor:
T = (Rp - rf) / Beta p - Sharpe:
T = (Rp - rf) / Sigma p - Jensen:
J = Rp - [rf + Beta p * (Rm -rf)] - Pre-specified standard deviation::
P = Rp - [rf + (Sigma p / Sigma m) * (Rm -rf)]
Explain the circumstances in which the different risk-adjusted measures are appropriate.
Circumstances in which different measures are appropriate
- Measures involving s are based on capital market line, which applies only to efficient portfolios.
So, should be used only when considering entire portfolio. - Measures involving b are based on security market line and so can be used in any circumstances, ie entire portfolio or part of portfolio.
- Jensen and pre-specified standard deviation measures are appropriate if required level of risk is pre-specified.
- Unlike Treynor and Sharpe measures, they cannot be used to compare two managers taking different levels of risk.
