Chapter 17 - Investment Management

Question 1

Investment management techniques

Answer 1

2 main investment management techniques:

1. Active
   Active management is where the manager has few restrictions on the choice of investments, perhaps just a broad benchmark of asset classes.

Greater returns expected but can be offset by:
- extra costs involved in more regular transactions, particularly when attempting to make short-term gains
- risk that the manager’s judgement is wrong

2. Passive

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

Not entirely risk-free as the index may perform badly or there may be tracking errors.

Question 2

Tactical Asset Allocation

Answer 2

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

Factors to be considered before making a tactical asset switch are
- 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
- problems of switching a large portfolio of assets such as shifting market prices
- tax liability arising if a capital gain is crystallised
- the difficulty of carrying out the switch at a good time

Question 3

Risk Budgeting

Answer 3

Risk budgeting is 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.

For investment risks, the risk budgeting process has two parts:
1. deciding how to allocate the maximum permitted overall risk between total fund active risk and strategic risk
2. allocating the total fund active risk budget across the component portfolios

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.

Question 4

Strategic , Active , Structural & Overall Risk

Answer 4

Strategic benchmark is the appropriate asset mix must be established for the fund

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.

Strategic risk reflects both the risk of the matched benchmark relative to the liabilities and the risk taken by the strategic benchmark relative to the matched benchmark.

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.

Structural risk is 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 5

Measuring different investment risks

Answer 5

Tactical Asset Allocation Risk is the risk of following an active investment strategy rather than tracking the benchmark index.

1. Historic tracking error
   Annualised standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance.
2. 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. This measure is derived by quantitative modelling techniques.

Both historic and forward looking tracking error measures can be used to measure strategic asset allocation risk

Counterparty, interest rate and equity market risk are difficult to measure.
The best proxy to quantify the risk being taken is to use the amount of capital that is necessary to hold against the risk.

South African firms subject to SAM 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.

Diversification benefits
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

Diversification within and across asset classes reduces exposure to specific risk.

In theory, a wholly diversified portfolio should have zero specific risk (and therefore only be subject to systematic risk).

Question 6

Analysing Investment portfolio performance vs benchmark

Answer 6

Can use time and money weighted rates of return