Chapter 21: Portfolio Management (2) Flashcards
Two conflicting objectives of portfolio construction: (2)
- reduce risk (often in terms of solvency and stability of cost)
- achieve higher long-term investment returns
Outline the two-stage process for establishing an investment policy.
- establishing the strategic benchmark or investment strategy.
- the tactical implementation of this strategy 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.
Risks involved in portfolio construction (3)
- strategic risk - the risk of the strategic benchmark relative to the liabilities
- active risk - the risk taken by the manager relative to his given benchmark
- structural risk - where the aggregate of the individual manager benchmarks does not equal the total benchmark for the fund.
The use of multifactor models (2) Hint: actively and passively
- actively - to estimate appropriate required return on a share in order to determine if it is cheap or dear.
- passively - to identify a suitable portfolio of shares to match liabilities or replicate an index.
Technical analysis
Based on patterns of past prices and trading volumes
Three main forms of technical analysis
- Chartism - examining charts of past market data
- Mechanical trading rules - where by trading signals are given by set price movements
- Relative strength analysis - which examines the performance of a share relative to the market as a whole or its own sub-sector.
Define risk budgeting
risk budgeting is a process that allocates risk to those areas of the portfolio where it is most efficient in terms of generating higher returns.
The risk budgeting process involves: (2)
- deciding how to allocate the maximum permitted overall risk to “total fund active risk” and “strategic risk”.
- allocating the total fund active risk budget across the component portfolios.
In practice, the following steps are involved in Risk budgeting: (4)
- define a feasible set of asset classes
- choose an initial asset allocation using a risk optimiser and a Value at Risk assessment to determine the risk tolerance.
- monitor risk exposures
- rebalance the portfolio when necessary due to changes in risk appetite or changes in underlying volatility and correlation data.
Principal function of a custodian
The principal function of a custodian is to ensure that financial instruments are housed under a proper system that permits investment for proper purposes with proper authority.
Custodians perform a variety of services, including: (7)
- income collection
- tax recovery
- cash management
- security settlement
- foreign exchange
- stock lending
- exercise voting rights on behalf of the manager or trustees.
Define Strategic risk: (2)
- Strategic risk is the risk of poor performance of the strategic benchmark relative to the value of the liabilities.
- It reflects the amount of systematic risk that the investor is willing to accept in an attempt to enhance long-term investment returns.
Problems associated with the practical use of multifactor models: (2)
- identifying the factors that affect the expected return on any particular security
- estimating the relationships between those factors and the expected returns.
The possible advantages of technical analysis (TA) are: (4)
- It is easy to collect the necessary data for TA
- TA is relatively quick and easy to carry out
- TA can be helpful with decisions on the timing of investment
- If you find a technique that works reliably, TA can be used to make short-term trading profits.
The possible disadvantages of technical analysis (TA) are: (3)
- Relying upon TA might distract the investor’s attention from more important considerations such as long-term value.
- Instead of making short-term profits you could end up making hefty losses.
- TA might encourage a more active trading strategy increasing expense levels.
Active money
The deviation from the benchmark portfolio for a specific position is usually termed the active money of that position in isolation.
Information ratio
The ration between the relative return and the historical tracking error.
Downward semi-standard deviation
the standard deviation of returns below the benchmark
Value at Risk
Value at Risk generalises the likelihood of under-performing by providing a statistical measure for downside risk. VaR assess the:
- potential losses on a portfolio
- over a given future time periods
- with a given degree of confidence
Financial stress testing
This involves subjecting the portfolio to extreme market moves by radically changing the underlying portfolio assumptions and characteristics, in order to gain insight into portfolio sensitivities to predefined risk factors.
Two types of stress test
- to identify ‘weak areas’ in the portfolio and investigate the effects of localised stress situations by looking at the effect of different combinations of correlations and volatilities.
- to guage the impact of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are ‘stressed’.
Define annualised historical tracking error:
It is the annualised standard deviation of the difference of portfolio return and benchmark return based on the observed historical performance
Define forward-looking tracking error:
It is 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.
It is derived by quantitative modelling techniques and depends on assumptions including:
- the likely future volatility of individual stocks or markets relative to the benchmark
- correlations between different stocks and/or markets.
