Chapter 17: Investment management Flashcards
Active investment management
- Investment manager has few restictions on investment choice within a broad limit.
- Expected to produce excess returns in an inefficient market.
- These returns may be eroded by dealing costs and risks of poor judgement
Passive investment management
- The investment manager has little choice
- As it involves holding assets closely related to those underlying an index or specified benchmark
- Risk of the index performing poorly as well as tracking errors
Tactical asset allocation
Short-term departure from benchmark position in persuit of higher returns
Considerations before making a tactical allocation
- The expected extra return compared to the expected risk
- The expenses
- The constraints on the chnages that I can be made to the portfolio - such as regulations
- Any problems with switching a large amount of assets -
There may be issues of marketibility - Tax liability arising
- The difficulty of carrying out the switch at a good time.
What balance must the investor strike when making a switch
Possible solution
- Selling the asset at a bad time
- The switch taking a long timr
Derivatives for exposure while you pay bit by bit
Risk budgeting
A process that establishes how much risk should be taken and where it is most efficient to take the risk (in order to maximise return)
Processes of risk budgeting
- Deciding how to allocate the maximum permitted risk between active and passive risk
- Allocating total fund active risk within the component portfolios
Explain the accuracy of testing for the performance of active funds
- There may be different constraints on the active managers that affect their performance relative to the trackers
- The amount of risk may be higher in the active manager’s portfolio - hence high returns, and not necessarily excess risk adjusted returns
- There will be a survivorship issue, ;leading to bias towards the funds that have performed well.
- Past performance does not act as a good guide for future performance
- The objectives of passive fund management and active fund management may be different.
What objectives are portfolios often constructed to meet
- Ensuring security
- Achieving high long-term returns
Steps in setting up an investment policy
Establish an appropriate mix of assets - strategic benchmark
* Consider nature liabilities - real vs. norminal
* Consider PRE (Investors instead of policyholders in this case)
Strategy is implemented by the selection of investment managers and a decision on the appropriate level of risk that these managers should take relative to the strategic benchmark - Active risk
* Within their guidelines, investment managers have freedom over stock selection
Risks that are involved in the process of quantifying risk
- Active risk
- Strategic risk
- Structural risk
Explain the following risks:
* Active risk
* Strategic risk
* Structural risk
Active risk
* The risk taken by investment managers relative to benchmarks
* Zero-active risk - simply track an index
Strategic risk
* The risk that the strategic benchmark does not match liabilities
* 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
Structural risk
* Where the aggregate of the individual investment manager benchmarks does not equal the total benchmark of the fund - investment in the fund or peers may change and there may be a delay in understanding the change
Why is it necessary to review an investment strategy at regular intervals
- The liability structure may have changed significantly
- The funding or free assets may have changed significantly
- The manager’s performance may be significantly out of line with that of other funds.
Tactical asset allocation
The risk of following an active investment strategy rather than tracking the benchmark index
Ways of measuring investment risks
- Historical tracking error
- Forward-looking tracking error
