Chapter 16-Investment management

Question 1

1. What are the two distinct approaches to managing investments?

Answer 1

In managing investments, whether directly or through a specialist manager, there are two distinct approaches that can be adopted - active management and passive management.

Question 2

2. What is meant by the term ‘active’ management?

Answer 2

Active management is where the manager has few restrictions on the choice of investments, perhaps just a broad benchmark of asset classes. This enables the manager to make judgements regarding the future performance of individual investments, both in the long term and the short term.

Question 3

3. What is meant by the term ‘passive’ management?

Answer 3

Passive management is the holding of assets that closely reflect those underlying a certain index or specific benchmark. The manager therefore has little freedom to choose investments.

Question 4

4. Compare active and passive management.

Answer 4

Active management is generally expected to produce greater returns due to the freedom to apply judgement. However, this is likely to be offset by the extra costs involved in more regular transactions, particularly when attempting to make short-term gains.
Active management also carries the risk that the manager’s judgement is wrong and so the returns are lower. Passive investment is not entirely risk free as the index may perform badly or there may be tracking errors.

Question 5

5. Explain the term ‘tactical asset allocation’.

Answer 5

An attempt to maximise returns may involve tactical asset allocation which is a departure from the benchmark position and hence conflict with the minimisation of risk. The size of the assets relative to the liabilities will determine the risk involved in such an action.

Question 6

6. What four factors should be considered before making a tactical asset switch?

Answer 6

Factors to be considered before making a tactical asset switch are:
* the expected extra returns to be made relative to the additional risk (if any)
* constraints on the changes that can be made to the portfolio
* the expenses of making the switch
* the problems of switching a large portfolio of assets.

Question 7

7. Describe the risk budgeting process.

Answer 7

The term risk budgeting refers to the process of establishing 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:
* decide how to allocate the maximum permitted overall risk between total fund active risk and strategic risk
* allocate the total fund active risk budget across the component portfolios.
The key focus when setting the strategic asset allocation is the risk tolerance of the stakeholders in the fund. This is the systematic risk they are prepared to take on in the attempt to enhance long-term returns. The key question on active risk is whether it is believed that active management generates positive excess returns.

Question 8

8. Describe the advantages of risk budgeting approach to asset allocation.

Answer 8

Risk budgeting is, therefore, 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.
A risk budgeting strategy can free the manager to look for alternative investments that might increase the expected return on the portfolio. Because the constraint is that the total risk of the portfolio must stay at or below a targeted level, increased attention is paid to low correlation investments. Allocations to such investments can reduce the total risk of the portfolio through diversification.

Question 9

9. Discuss the two conflicting objectives faced by investment fund managers.

Answer 9

In managing an investment fund, managers will often face two conflicting objectives:
* to ensure security
* to achieve high long-term investment 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.

Question 10

10. Define the following terms: ‘strategic risk’, ‘active risk’, ‘structural risk’ and ‘overall risk’ in the context of determining suitable investments to meet the two objectives above.

Answer 10

This will typically involve a two-stage process:
1. Firstly, an appropriate asset mix must be established for the fund - the strategic benchmark. This will be set taking into account the nature of the liabilities, and any representations about the structure or asset mix of the fund that have been made to investors. The tools described in this and the previous chapters can be used in setting the strategic benchmark. The strategic (or policy) risk of the fund is the risk of poor performance of the strategic benchmark relative to the value of the liabilities.
2. Secondly, the strategy is implemented 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. Within their guidelines, the investment managers have freedom over stock selection, and use their skills and research to maximise the return on the funds allocated to them. The allocation of this part of the investment risk budget is known as the active (or manager or implementation) risk.
There may also be some structural risk associated with any mismatch between the aggregate of the portfolio benchmarks and the total fund benchmark.
The overall risk is the ‘sum’ of the active, strategic and structural risks.

Question 11

11. Explain why it is necessary to review the continued appropriateness of any investment strategy at regular intervals.

Answer 11

It is necessary to review the continued appropriateness of any investment strategy at regular intervals because:
* the liability structure may have changed significantly
* the funding or free asset position may have changed significantly
* the manager’s performance may be significantly out of line with that of other funds.

Question 12

12. Explain how setting performance targets for investment managers is carried out.

Answer 12

In some cases, an investment manager will work to a performance objective in which the return is judged relative to that achieved by other managers for similar funds.
The more severe the restrictions placed on the managers on the assets or asset classes that can be held, the less appropriate it is to set performance targets that relate directly to the generality of funds.

Question 13

13. Outline what the target return should be compared against.

Answer 13

The target return should therefore be compared against that which will have been achieved by an index fund, which had maintained the asset allocation proportions set in the benchmark.

Question 14

14. What are the potential problems which can arise from any constraints that may have affected the investment manager’s performance?

Answer 14

It is also important to note any other constraints that may have affected the manager’s performance, such as a shortage of cashflow within the provider. This may restrict the funds available for investment or lead to disinvestments that may not be timed as well as would otherwise be the case.

Question 15

15. Define tactical asset allocation risk.

Answer 15

Tactical asset allocation risk is the risk of following an active investment strategy rather than tracking the benchmark index.

Question 16

16. Outline how the historic tracking error is calculated.

Answer 16

The most usual measure adopted is the retrospective or backwards-looking tracking error - the annualised standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance.

Question 17

17. Define the forward-looking tracking error.

Answer 17

The equivalent prospective measure is the forward-looking tracking error - 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.

Question 18

18. Outline how the above can be derived.

Answer 18

This would include investment risks relating to liabilities, eg due to mismatching. The ratio of the actual to the expected occurrences when the risk was accepted would be monitored.

Question 19

19. Outline how strategic asset allocation risk can be measured.

Answer 19

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.

Question 20

20. Outline how duration risk can arise.

Answer 20

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.

Question 21

21. What is the best proxy to quantify the risk being taken?

Answer 21

The best proxy to quantify the risk being taken is to use the amount of capital that is necessary to hold against the risk.

Question 22

22. Outline how financial providers determine this proxy.

Answer 22

This is relatively straightforward for financial product providers who have to carry out a capital requirements calculation. Firms subject to the European Solvency II regime can use their internal model or the standard formula, as appropriate. It is then possible to calculate the capital required for a target portfolio and the actual portfolio as measures of the risks taken.

Question 23

23. When measuring risks and considering the associated costs, it is also necessary to allow for what benefits?

Answer 23

When carrying out the above analysis of the costs of risk, it is also necessary to allow for the benefits of diversification, which can be assessed using similar techniques.

Question 24

24. Explain why the traditional formulae used to analyse the performance of a fund manager against a benchmark are no longer used in practice.

Answer 24

Traditionally there have been various formulae used to analyse the performance of a fund manager against the benchmark allocated. None of these are now used in practice. This is because the commonly used benchmarks are calculated at least daily, and for some major indices an index value is available at any time in the day.

Question 25

25. Describe the current simplest way of comparing the actual performance of a fund against its benchmark.

Answer 25

The simplest way of comparing the actual performance of a fund against its benchmark is to input all the cashflows that went into or out of the fund onto a spreadsheet that also holds the daily values of the benchmark. Therefore, it is possible to calculate readily the value of the fund over a period if it had been invested in the benchmark rather than in the actual assets held.

Question 26

26. Overall, what will the approach depend on?

Answer 26

Care needs to be taken over the treatment of income; in particular whether a benchmark index includes reinvestment of income:
* If the index includes income reinvested, then dividends and interest on the actual portfolio are excluded as cashflows (but included in valuing the new end-period value of assets).
* If the benchmark is capital only then the actual income from the assets held needs to be included as cashflows.
The approach used will depend on whether the manager is assessed on capital or total investment performance.

Question 27

27. Explain why the frequency of performance monitoring is important.

Answer 27

A decision will be needed on how frequently performance is to be monitored. This should be regular enough to achieve the company’s objectives, to be confident that it can monitor performance, but mindful of the expense of monitoring too frequently. Most investment mandates are designed for medium- to long-term performance, so care must be taken not to overstate the impact in the very short term of market fluctuations.

Question 28

28. What could be monitored relative to a liability benchmark?

Answer 28

Performance of an overall investment strategy may also be monitored relative to a liability benchmark.

Question 29

29. Assess the two methods of measuring the performance or the rate or return on an investment portfolio and their limitations.

Answer 29

Money-weighted and time-weighted rates of return are two methods of measuring the performance or the rate of return on an investment portfolio. Each of these two approaches has particular instances where it is the preferred method.
A money-weighted rate of return (MWRR) is identical in concept to an internal rate of return: it is the discount rate at which the present value of inflows = present value of outflows in a portfolio. The MWRR allows for all cashflows and their timing, and is the same approach as described above.
It is important to understand the main limitation of the MWRR as a tool for evaluating managers.
The MWRR factors in all cashflows, including contributions and withdrawals. Assuming a MWRR is calculated over many periods, the formula will tend to place a greater weight on the performance in periods when the account size is highest (hence the label moneyweighted). If a manager outperforms the benchmark for a long period when an account is small, and then (after the client deposits more funds) the manager has a short period of underperformance, the money-weighted measure may not treat the manager fairly over the whole period.
Deposits and withdrawals are usually outside a manager’s control; thus, a better performance measurement tool (than MWRR) is needed to judge a manager more fairly and allow for comparisons with peers - a measurement tool that will isolate the investment actions, and not penalise for deposit / withdrawal activity.
The time-weighted rate of return (TWRR) is the preferred industry standard as it is not sensitive to contributions or withdrawals. 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.
Dividend income can be assumed to be reinvested or not, as required. This is the same basis on which benchmark indices are calculated, so it has the advantage of comparing like with like.
Using the TWRR will not identify the manager who has a skill at managing small funds and is weak at managing large funds, or vice versa.
It is important to understand the consequences of the assessment method used and to choose that most appropriate for the circumstances of the business and the purpose of the comparison.

Question 30

30. Explain why it is important to capture the relevant benchmark indices at the same time as the pricing point for units within a collective investment scheme.

Answer 30

Collective investment schemes have a daily (sometimes less frequent) pricing point. This is the time of day at which the values of the underlying assets in the scheme are captured. It is commonly noon or 3pm and is rarely at market close. Published market indices are normally quoted at close of business.
Intra-day movements in certain markets can be material and so to make a fair assessment of the scheme manager it is necessary to capture the relevant benchmark indices at the same time of day as the pricing point. Not all market indices are available publically on a continuous basis.