Chapter 22: Portfolio Management (2) Flashcards
o.i) principal techniques pf management and risk control
State the:
- two conflicting objectives that may be faced by the manager of an investment designed to cover liabilities
- two stages in the pf construction process.
Pf construction
Conflicting objectives:
1. Ensuring the safety of liabilities (ie solvecy) and stability of costs/profits
2. Achieving high long-term investment returns, to reduce cost/increase profit
While the first objective encourages matching of liabilities to assets, the second may involve mismatching to achieve high returns.
Two stages of pf contruction:
The investment policy needs to reflect the extent to which the risk of low stability and security is are taken in order to enhance returns and this is done through:
1. Establishing a strategic asset allocation benchmark
- this stage focus on LT asset allocation
- it defines risk tolerances and investment objectives
- it prioritises stability and security over short-term gains
2. Tactical implementation of strategy by selecting one or more investment managers and deciding the appropriate level of risk they should take relative to strategic benchmark.
- this stage focuses on ST implementation of strategic plan
- allows managers to take advantage and exploit market movements within an exceptable range.
o.i) principal pf management and risk control (active management styles)
List the 15 factors to consider influencing investment strategy that appear in subject CA1/CP1
Remember these using SOUNDER TRACTORS
Pf construction
- Size of assets - absolute and compared to liabilities
- Objectives of the fund
- Uncertainty of the existing liabilities
- Nature of the existing liabilities
- (need for) Diversification
- Existing pf
- Risk appetite/tolerance
- Term of the existing liabilities
- Return from various asset classes
- Acrrual of future liabilities
- Currency of the existing liabilities
- Tax (and expenses)
- Other funds (and factors, e.g., expertise)
- Restrictions on how fund may invest
- Statutory valuation, solvency and accounting requirements,
o.i) principal pf management and risk control (active management styles)
Explain what is meant by each of the following:
- strategic risk
- active risk
- structural risk
Pf construction
Strategic risk
- it is the risk that the strategic asset allocation benchmark will underperform the value of liabilities (discount rate used to value L)
- which is often quantified with reference to the matching benchmark - pf deemed to closely match liabilities
- it may reflect both the risk of the matched benchmark relative to the liabilities and the risk taken by the strategic benchmark relative to the matched benchmark.
- It reflects the amount of systematic risk that the investor is willing to accept in an attempt to enhance long-term investment returns
Active risk
- for each individual specialist manager, active risk is the risk that he under-performs relative to his particular strategic benchmark. Total active risk is risk that managers in aggregate under perform relative to aggregate of individual benchmarks.
- this is measured as s.d of active return (often measured in terms of tracking error)
- active return is the return that an active manager achieves relative to his particular strategic benchmark
Structural risk
- Risk that aggregate individual manager’s pf benchmarks underperform relative to the total fund benchmark
0.viii) multifactormodels usefulness in prac invest man & risk control
Outline the two main uses of multifactor modes in pf management.
The use of multifactor models
- Identify mis-priced assets - by comparing the required return according to the model with expected return based on the price.
- Controllling exposure of the pf to different factors, in order to match liabilities or track an index.
0.viii) multifactormodels usefulness in prac invest man & risk control
State the formula for a multifactor model.
The use of multifactor models
Multifactor model attempts to explain the observed historical investment returns of security i as a function of systematic risk, which may be macroeconomic variables and/or company-specific factor. It is represented by the by an equation:
R(i) = a(i) + b(i)_1l_1 + b(i)_2l_2 + …+ b(i)_L*l_L + c(i)
a(i) and c(i) –> constants and random parts respectively of the componet return unique to i
l_1…l_L - changes in the set of L factors that explain the variation in R(i) about the expected return a(i)
b(i)_k –> sensitivey of security i to factor k
0.viii) multifactormodels usefulness in prac invest man & risk control
Outline the use of multifactor models in index tracking (and passive management)
The use of multifactor models
- Multifactor models can be used to identify and control the exposure of a portfolio (assets) to the
different risk factors and to change the risk profile of the portfolio to better match the exposure of the (liabilities) index being tracked. - This is because they can be used to examine the relationships between both the assets and the (liabilities) index and the various economic influences and other risk factors.
- By quantifying the impact of various risk factors upon both assets and the (liabilities) index, such models enable the fund manager to select the assets so that their exposure to each risk factor is similar to that of the (liabilities) index being tracked.
- Consequently the assets and (liabilities) index should be broadly matched, thereby reducing the
manager’s exposure to tracking error (mismatching risk). - Multifactor models can then be used in conjunction with stratified sampling (choosing a
sample of shares that broadly reflect the various characteristics of the shares in the index) - Multifactor models can also be used in conjunction with the synthetic fund approach
(choosing a combination of cash and derivatives to broadly replicate the performance of
the index being tracked).
0.viii) multifactormodels usefulness in prac invest man & risk control
Outline the use of multifactor models in Active management
- passive management
LIst the two key problems with multifactor models.
The use of multifactor models
Active management
- Can be used to estimate the appropriate expected return of a share given the set of risk factors and estimated factor returns
- if risk factors (sources of systematic risk e.g., inflation, economic growth and currency movements) can be predicted with greater certainty than the market, the out-performing shares or sectors can be identified
- can also use the model to quantify portfolio exposure to particular risk factors
- and where desired to alter this exposure
- This could for example facilitate better matching of liabilities
- …if we have a good sense of the liabilities’ exposure to these risk factors.
Passive management
- can be used to examine the relationship between asset and liability values and various economic influences
- thus enable the investor to select assets whose exposure to to certain risk factors is similar to that of the liabilities (A and L broadly matched)
- same approach can be used to determine a set of assets that replicate expected performance of an index.
Problems with MF models
1. identifying factors that affect the expected return on any particular security.
2. estimating the relationship between those factors and the expected returns
- random variation
- relationship may vary overtime and hence estimate based on past data may not be applicable in future
o.i) principal techniques pf management and risk control
Explain what is meant by tehcnical analysis and list the three main forms.
Technical Analysis
Technical analysis
- is the study of past market variables such as prices, yields and trading volumes in order to predict or anticipate future prices and yields.
- it is used for individual securities, level of the entire investment market, currency values and commodities.
- it only makes sense only if the particular investment market is believed to be inefficient
Three main forms
1. Chartism
2. mechanical trading rules
3. relative strength analysis
o.i) principal techniques pf management and risk control
Explain what a chartist does.
Outline extent to which chartism works and whether it is used.
Technical Analysis
- Tries to identify patterns and trends in prices and/or yields by looking at charts.
- then takes action based on the probability that past pattern of behaviour will be repeated in future.
- A charstist may justify his approach by linking the repeatability of patterns with investor psychology.
- support levels –> falls below this –> sell
- resistence levels –> breaks this –> buy
Does it really work?
- A chartist must identify a pattern before any other chartist can
- chartists are forced to anticipate patterns before they are fulled formed
- cometition between chartists may compete patterns away
- chartism is almost exclusively involved with ST movements…
-…whereas FA is used for LT and strategic decisions.
o.i) principal techniques pf management and risk control
Explain with the aid of a simple example, how mechanical trading rules work.
Outline how relative strenght analysis works.
Technical Analysis
Mechanical trading rules
- Trading rules are given by set price movements and acted on mechanically.
- Although the trading rule is objective, its subsequent implementation is not.
- for example, share may bought if it moves up by x% from a previous low, or sold if it moves down by y% from a previous high. If x% and y% are too small, any profits will be lost through expenses of excessive trading. if values are high, then substantial movements would have occured before trade can be executed and so potential profits lost.
Relative strength analysis
- examines share performance relative to market or sector
- can be used to identify, at early stage, a change in relative strength which is unlikely to recur in the immediate future…
- …(based on mean reversion)
- or to buy (sell) stocks which have out-(under-)performed in the short-term past, in the belief that this performance will persist in the short-term future
- …(based on momentum)r
o.i) principal techniques pf management and risk control
List three possible advantages and three possible disadvantages of TA.
Technical Analysis
Advantages
1. it is easy and quick collect data and carry it
2. Can be helpful with decisions on timing of investment
3. May help make ST trading profits
Disadvantages
1. Could distrate an investor away from important considerations such long-term value
2. Instead of short-term profits, you could end up making hefty losses
3. Might encourage more active trading strategy increase expense levels.
Discuss the differences between FA and TA.
Active vs. Passive and Costs
- Both active styles (technical and fundamental) aim to outperform the market by exploiting inefficiencies.
- Active trading incurs higher costs (trading fees, management fees) than passive investing.
Technical vs. Fundamental Analysis
Technical Analysis:
- Analyzes past price/volume data to predict future trends.
- Short-term focus, exploiting short-lived market inefficiencies.
- Success depends on the manager’s skill in identifying patterns before others.
Fundamental Analysis:
- Analyzes a company’s financial health and future prospects (dividends, earnings).
- Long-term focus, relying on mispriced assets reverting to their fundamental value.
- Success depends on accurate valuation of fundamental
- Likely more expensive due to greater volumes and types of research and data required to value a company
o.i) principal techniques pf management and risk control
Explain what is meant by risk budgeting.
Is the process of establishing overall investment risk and where it is more effecient to take that risk to maximise return.
It involves two stages:
1. deciding how to allocate overall max overall risk to strategic risk and total fund active risk
2. allocating total fund active risk between component pfs.
e.g., deciding how risk each individual specialist manager can take.
Risk budgeting
o.i) principal techniques pf management and risk control
Explain outline key to be considerations in relation to the total active fund and problems that arise when assessing performance. Also key consideration in relation to strategic risk.
Risk budgeting
Key considerations:
- is it believed that active management generates positive excess returns
- estimates information ratios that each manager is thought to be able to obtain which that can be used to determine the allocation of active risk between individual managers.
how to test if active management generates returns:
- compare LT performance of a selection actively managed funds against that of a number of index tracker funds
Problems that arise:
- different constraints on active managers that affect performance relative to trackers
- amount of risk higher in active manager’s pf
- ‘surviviorship’ issue –> many poor performing active funds cease to gain new business and wind up –> bias towards those active funds that perform adequately
- past performance does not act as good guide for future performance
- objectives of active and passive managers may be different
Strategic risk:
- Key focus is the risk tolerance of the stakeholders in the fund –> how much systematic risk they are prepared to take on in their attempt to enhance long-term return –> assessed using downside risk measures (VaR)
o.i) principal techniques pf management and risk control
Outline what is done in each of the first two steps in the risk budgeting process.
Risk budgeting
First step:
- Define ‘feasible set’ - set of asset classes that can be included in the pf
- obtain estimates of volatilities and covariances of each asset class.
Second step:
This stage involves choosing the initial asset allocation by using some risk/return analysis and an assessment of VaR to determine risk tolerances.
- use to an asset-liability model to determine the matching benchmark
- perform VaR risk calculations to determine total fund risk budget
- allocate the total risk budgest between strategic risk and total ative risk
- determine the investment strategy (by further modelling of risk adn returns)
- allocate total active risk to between different investment managers (and determine individual manager’s benchmarks and guidelines)
