Chapter 17: Investment management Flashcards
What is active investment management ?
Active investment management
Active approach involves actively seeking out under- or over-priced assets which can then be traded in attempt to enhance investment returns
Involves making short-term tactical deviations away from benchmark strategic position
Likely to involve switching between assets
Active management = where manager has few restrictions on the choice of investments, perhaps just broad benchmark of asset classes
Enable manager to make judgments regarding future performance of individual investments – in long and short term
Active management could achieve higher returns by identifying:
- Under-or over-priced sectors to make sector selection profits
- Individual stocks that are under-or over-priced to make stock selection profits
Generally expected to produce greater returns due to freedom to apply judgement
But this is likely offset by:
- Extra costs involved in more regular transactions – particularly when attempting to make short-term gains
- Risk that manager’s judgement is wrong, and returns are lower
Producing greater returns will not be possible if investment market is efficient
Active investment management is appropriate if investor believe that investment market is inefficient
What is passive investment management?
Passive investment management
Passive management = is holding assets that closely reflect those underlying a certain index or specific benchmark
Manager has little freedom to choose investments
E.g. index tracking – where investor selects investments to replicate the movements of a chosen index
Portfolio then changed only in response to changes in the constituents of the index
Less expensive than active strategy
Not entirely risk-free as index may perform badly or there may be tracking errors
Investor might choose to combine active and passive approaches
Managing assets actively within some asset classes and sectors and passively within others
What is tactical asset allocation and tactical decisions?
Tactical asset allocation
Tactical decisions involve short-term switching between investments in pursuit of higher returns
Contracts with strategic investment decisions which involve setting long-term structure of a portfolio
Attempt to maximize return may involve tactical asset allocation – which is departure from benchmark position and hence conflicts with minimization of risk
Size of assets relative to liabilities will determine risk involved
Thus, investor may make short-term tactical deviations away from long-term strategic asset allocation,
in order to take advantage of temporary under- or over-pricing of assets
Done if extra expected returns from doing so outweigh the additional risk incurred
Factors to consider before making tactical asset switch:
- expected extra returns relative to additional risk (if any)
- constraints on changes that can be made to portfolio
- expenses of making the switch
- problems of switching large portfolio of assets – shifting market prices
- tax liability arising is capital gain is crystallised
- difficulty of carrying out switch at good time
Problems acute when unmarketable securities are involved
In making the switch, there is balance between:
- selling the asset at bad time
- the switch taking a long time
Partial solution is to use derivative to gain required exposure immediately and then conduct a gradual sale of the portfolio
Why is it necessary to review the continued appropriateness of any investment strategy at regular intervals?
Monitoring investment performance and strategy
Necessary to review the continued appropriateness of any investment strategy at regular intervals because:
- the liability structure may have changed e.g. following the writing of new class of business, takeover or legislation
- the funding or free asset position may have changed
funding position – used when referring to defined benefit scheme free assets or surplus or solvency position – when referring to insurer - the manager’s performance may be out of line with that of other funds
What is considered when setting performance objectives and what are some constraints on the manager’s performance?
Setting performance objectives
Investment manager will work to performance objective in which return is judged relative to that achieved may other managers for similar funds
More severe the restrictions placed on the managers on the assets or asset classes that can be held – less appropriate it is to set performance targets that relate directly to generality of funds
Target return should thus be compared against that which will have been achieved by an index fund – which had maintained asset allocation proportions set in the benchmark
Some investment managers are given significant investment freedom
Other schemes specify a strategic investment norm or benchmark and operating bands around this norm – to allow managers to take tactical decisions in pursuit of greater investment performance
Asset-liability modelling can help to set appropriate strategic investment policy for scheme and also to review policy from time to time
Constraint on the manager’s performance
NB to note any other constraint that may have affected manager’s performance e.g. shortage of cashflow within the provider
May restrict the funds available for investment or lead to disinvestments that may not be timed as well as would otherwise be the case
How are some of the investment risks measured? - Tactical asset allocation risk
Tactical asset allocation risk
The risk of following an active investment strategy rather than tracking the benchmark index
Historic tracking error
Most usual measure adopted is retrospective or backwards-looking tracking error
This is the annualised standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance
This is generally the standard deviation of difference between two returns
Forward-looking tracking error
Equivalent prospective measure is the forward-looking tracking error
An estimate of the standard deviation of returns (relative to benchmark) that the portfolio might experience in future if its current structure were to remain unaltered
This measure is derived by quantitative modelling techniques
Forward predictions generally based on volatility and correlation data that is derived from past performance
Hence there is element of backward-looking
However, does allow us to model current portfolio going forward, rather than historical portfolio, which might have changed considerably over time
How are some of the investment risks measured? - Strategic asset allocation risk
Strategic asset allocation risk
Where overall portfolio is managed by single manager, manager will normally be given target range of asset allocation as a % of fund
A target asset allocation which may not always be center point of individual ranges will also be provided
Can be measured using forward- and backward-looking approaches – assuming that relevant parts of portfolio were invested in appropriate benchmark indices and effects of actual strategic allocation compared with target allocation
How are some of the investment risks measured? - Duration risk
Duration risk
Portfolio that needs to closely match assets with liabilities will also have target and acceptable range for duration of the fixed interest element
Otherwise the investments may be:
- Too long for liabilities (leading to liquidity risk)
- Too short for liabilities (leading to reinvestment risk)
Above techniques can be used to measure risk taken by departing from target duration
How are some of the investment risks measured? - Counterparty, interest rate and equity market risk
Counterparty, interest rate and equity market risk
More difficult to quantify
Best proxy to quantify the risk being taken is to use amount of capital that is necessary to hold against the risk
Relatively straightforward for financial product providers who have to carry out capital requirements calculation
SA firms subject to SAM can use their internal model or standard formula
Then possible to calculate capital required for target portfolio and actual portfolio as measures of the risks taken
How are some of the investment risks measured? - Diversification benefit
Diversification benefits
Necessary to allow for benefits of diversification – which can be assessed using similar techniques
How can the investment performance be analysed?
Comparative performance
Various formulae used to analyse the performance of fund manager against benchmark allocated
None of these are now used in practice
Because commonly used benchmarks are calculated at least daily and for some major indices an index value is available at any time of day
Simplest way of comparing the actual performance of fund against its benchmark is to input all cashflows that went into or out of fund onto spreadsheet that also holds daily values of benchmark
Thus, possible to calculate readily the value of fund over a period if it had been invested in benchmark rather than in actual assets held
Care needs to be taken over treatment of income; in particular of benchmark index includes reinvestment of income
- If index includes income reinvested – then dividends and interest on actual portfolio are excluded as cashflows
- If benchmark is capital – only then the actual income from assets held needs to be included as cashflows
Approach used will depend on whether manager is assessed on capital or total investment performance
Comparison must also allow for fees
Alternatively, may be possible to exclude fees out of both and look at fees separately
Decision will be needed on how often performance is monitored
Regular enough to achieve company’s objectives, to be confident that it can monitor performance but mindful of expense of monitoring
Most investments are designed for medium- to long-term performance – so care needed to not overstate the impact in very short term of market fluctuations
Analysis of reasons for departures from benchmark performance could be sought form manager
NB to help understand how investment strategy should be altered (if at all)
Performance of an overall investment strategy may also be monitored relative to liability benchmark
What are the two methods of measuring the performance or rate of return on investment portfolio?
Time-weight and money-weighted rates of return.
Discuss the money-weighted rate of return.
Money- weighted rate of return
MWRR is identical in concept to internal rate of return: it is the discount rate at which the PV of inflows = PV of outflows in a portfolio
Allows for all cashflows and their timing and is same approach as above
Only takes account of new money into fund or money disinvested by fund
Any cashflows generated by the fund itself are ignored
NB to understand the main limitation of MWRR
MWRR factors in all cashflows, including contributions and withdrawals
Assuming MWRR is calculated over many periods – formula will tend to place greater weight on performance in periods when account size is highest
If manager outperforms benchmark for long period when account is small and then (after client deposits more funds) manager has short period of underperformance, MWRR may not treat manager fairly over whole period
Discuss the time-weighted rate of return.
Time-weighted rate of return
Deposits and withdrawal are usually outside manager’s control
Thus, better performance measurement tool than MWRR is needed to judge manager more fairly and allow for comparison with peers
I.e. a measurement tool that will isolate investment actions and not penalize for deposit/withdrawal activity
TWRR is the preferred industry standard as it is not sensitive to contributions or withdrawals
Calculate the growth factors reflecting the change in value of the fund between times of consecutive cashflows
Then combine these growth factors to come up with overall rate of return for whole period
TWRR found from product of the growth factors between consecutive cashflows
Defined as compounded growth rate of 1 over the period being measured
No account is taken of flows of money into or out of the portfolio
Cashflows in formula for calculating TWRR only include those relating to new money
Any cashflows generated by fund itself must be taken into account in the figures for the fund value
Dividend income assumed to be reinvested or not as required
This is same basis on which benchmark indices are calculated so it has advantage of comparing like with like
MWRR places greater weighting on periods when fund size is largest
NB to understand consequences of assessment method used and to choose most appropriate for circumstances of the business and purpose of the comparison
How is the performance of a CIS analysed?
Collective investment schemes
CISs have a daily (sometimes less frequent) pricing point
This is time of day at which values of underlying assets in scheme are captured
Published market indices are normally quoted at close of business
Intra-day movements in certain markets can be material – so to make fair assessment of scheme manager it is NB to capture relevant benchmark indices at the same time of day as pricing point
Not all market indices are available publicly on continuous basis
