Chapter 17: Investment management

Question 1

Active investment strategy

Answer 1

The investment manager has
- few restrictions on investment choice within a broad remit.

This method is expected to produce greater returns despite extra dealing costs and risks of poor judgement.

Question 2

Passive investment strategy

Answer 2

Involves holding assets closely reflecting those underlying an index or specified benchmark.

The investment manager has little freedom of choice.

There remains the risk of

• tracking errors
• a poorly performing index / benchmark.

Question 3

2 parts of the risk budgeting process

Answer 3

1. Decide how to allocate the maximum permitted overall risk between active risk and strategic risk.
2. Allocate the active risk budget across the component portfolios (eg to the UK equity manager, to the UK bond manager).

Question 4

3 Types of risk (used in portfolio construction)

Answer 4

• strategic risk
• active risk
• structural risk

Question 5

Strategic risk

Answer 5

the risk that the strategic benchmark does not match the liabilities

Question 6

Active risk

Answer 6

The risk taken by the individual investment managers relative to the given benchmarks

Question 7

Structural risk

Answer 7

where the aggregate of the individual investment manager benchmarks does not equal the total benchmark for the fund.

Question 8

Risk Budgeting

Answer 8

The process of setting risk limits.

Setting an overall risk limit…
then deciding how to allocate the overall risk limit:
… across all the activities / sources that give rise to investment risk
… in order to maximise overall return
… within the overall risk limit

Question 9

Overall risk

Answer 9

The "sum" of the
- active,
- strategic,
- and structural
risks.

Question 10

Historic tracking error

Answer 10

annualised standard deviation of

.. . the difference between actual fund performance and benchmark performance.

Question 11

Forward-looking tracking error

Answer 11

involves modelling the future experience of the fund based on:

• its CURRENT holdings and
• likely FUTURE volatility and correlations to other holdings.

Question 12

2 (conflicting) objectives of portfolio construction

Answer 12

• reducing risk (often in terms of solvency and stability of cost)
• achieving high long-term returns

Question 13

The 2-stage process of achieving investment objectives

Answer 13

1. Establishing an appropriate asset mix for the fund. - the STRATEGIC BENCHMARK
2. The strategy can be 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.

Question 14

Tactical asset allocation

Answer 14

Departure from the benchmark position in an attempt to maximise return.
this may conflict with the minimisation of risk.

Question 15

5 Factors to be considered before making a TACTICAL ASSET SWITCH

Answer 15

• level of the free assets
• expected extra return to be made relative to the additional risk
• constraints on the changes that can be made to the portfolio
• expenses of making the switch
• problems of switching a large portfolio of assets

Question 16

3 Sources of profit for active investment managers

Answer 16

• Asset class selection profits
• Sector selection profits
• Stock selection profits

Question 17

Reason for reviewing the appropriateness of any investment strategy

Answer 17

• The liability structure may have changed significantly
• Funding or free asset position may have changed significantly
• The managers performance may be significantly out of line with that of other funds

Question 18

Tactical asset allocation risk

Answer 18

the risk of following an active investment strategy rather than tracking the benchmark index

Question 19

Measuring strategic risk

Answer 19

Strategic risk can be measured using forward- and backward-looking approaches, assuming 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

Money-weighted rate of return

Answer 20

discount rate at which the PV of inflows = PV of outflows in a portfolio.
-The formula places a greater weight on performance when the fund size is the highest.

Question 21

Time-weighted rate of return

Answer 21

the compounded growth rate of 1 over the period being measured.
-No account is taken of flows in or out of the portfolio. It will not identify managers with skills at managing only funds of a particular size.