Chapter 22: Portfolio Management (2)

Question 1

State the

2 conflicting objectives that may be faced by the manager of an investment fund established to cover liabilities

2 stages in the portfolio construction process

Answer 1

2 conflicting objectives faced by investment fund covering liabilities

Ensuring security of liabilities (ie solvency) and stability of costs/profits

Achieving high long term investment returns, to reduce costs/increase profits

They may have some mis-matching to generate higher returns

2 stages of portfolio construction process

Establishing strategic benchmark asset allocation

Tactical implementation of strategy by selecting one of more managers and deciding appropriate level of risk they should take relative to strategic benchmark

Question 2

List 15 factors influencing investment strategy that appeared in CA1

Answer 2

Size of assets - absolutely and compared to liabilities 
Objectives of investor
Uncertainty of existing liabilities
Nature of existing liabilities 
Diversification
Existing portfolio
Restrictions on how fund may invest 
Term of existing liabilities 
Return from various asset classes 
Accrual of future liabilities 
currency of existing liabilities 
Tax
Other funds 
Risk appetite/tolerance 
Statutory valuation, solvency and accountancy requirements

Question 3

Explain what is meant by each of the following

Strategic risk
active risk
structural risk

Answer 3

Strategic risk

Risk that strategic benchmark under-performs relative to value of liabilities. Often quantified with reference to matching portfolio- portfolio deemed to most closely match liabilities

Active risk

For each individual specialist manager, active risk is risk that the fund under-performs relative to his particular benchmark. Total active risk is risk that managers in aggregate under-performs relative to aggregate of individual benchmarks

Structural risk

Risk that aggregate of individual managers’ portfolio benchmarks under-performs relative strategic benchmark

Question 4

Outline the two main uses of multi factor models in portfolio management

Answer 4

Identifying mis-priced assets - by comparing the required return according to the model with expected return based on the price

Controlling exposure of portfolio to different risk factors, in order to match liabilities or track index

Question 5

Explain what is meant by technical analysis and list its three main forms

Answer 5

Attempts to predict future prices and yields based on past prices, yields and/or trading volumes
Three main forms

Chartism
mechanical trading rules
relative strength analysis

Question 6

Explain what a chartist does

Answer 6

Tries to identify and trends in prices and/or yields by looking at charts
Then takes action based on probaility that past pattern of behaviour will be repeated in future

Question 7

Explain, with the aid of a simple example, how mechanical trading rules are used

Answer 7

Trading signals given by set price movements and acted on mechanically

although choice of trading rule is subjective, its subsequent implementation is not

For example, share may be bought if it moves up by x% from previous low, or sold if it falls more than y% from 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 price movements will have occured before trade executed and some potential profits lost

Question 8

Explain in detail how relative strength analysis works

Answer 8

Examine performance of share relative to market as whole or its own sub-sector

Can be used in two ways

To attempt to identify change in relative strength at early stage. If this is considered unlikely to happen again in immediate future, then share may be sold. Based on belief in mean reversion

To buy companies whose shares have out-performed in previous six months. Idea is that shares that have done well in fist six months will continue to do well in next six months as other investors see share doing well and want to participate in extra performance. Based on belief in momentum effects

Question 9

List three possible advantages and three possible disadvantages of technical analysis

Answer 9

Three possible advantages of technical analysis

Quick and easy to collect data and carry it out

Can be helpful with decisions on timing of investment

May help you make short term trading profits

Three possible disadvantages of technical analysis

Could distract investor’s attention from more important considerations such as long term value

Instead of short term profits, you could end up making hefty losses

Might encourage more active trading strategy increasing expense levels

Question 10

Explain what is meant by risk budgeting

Answer 10

Process of establishing overall investment risk to be taken and where it is most efficient to take risk in order to maximise return

Can be thought in two stages
Deciding how to allocate maximum overall risk between strategic risk and total fund active risk

Allocate total fund active risk across component portfolios, ie deciding how much risk each individual specialist fund manager can take

Question 11

Outline what is done in each of the first steps in the risk budgeting process

Answer 11

First step in risk budgeting process

Define 'feasible set' - set of asset classes that can be included in portfolio
Obtain estimates of volatilities and covariance of each asset class
Second step in risk budgeting process

Use asset - liability modelling to determine matching portfolio

Perform value at risk calculations to determine that total risk budget

Allocate total risk budget between strategic risk and total active risk

determine investment strategy

Allocate total active risk between different investment managers (and determine individual manager’s benchmark s and guidelines)

Question 12

Outline the third and fourth steps in the risk budgeting process

Answer 12

Third step in the risk budgeting process

Monitor risk exposures (Increases and decreases in values of positions) and changes in volatilities and correlations

Fourth step in risk budgeting process

Re-balance portfolio in response to changes in short term volatilities and correlations of assets

Allocations are altered to keep overall portfolio within risk budget

Question 13

Define

Relative return
Tracking error
Backwards looking tracking error
Forward looking tracking error

Answer 13

Relatiive return

Difference between portfolio return and benchmark return

Tracking error

Annualised standard deviation of relative return

Backwards - looking tracking error

Estimate of tracking error based on observed historical data from a recent past period. Measures average active risk taken over recent past period

Forward looking tracking error

Estimate of standard deviation of returns (relative to benchmark) that portfolio might experience in future if its current structure remains unaltered

Question 14

Explain what is meant by

Active money
Information ratio
And state what each tells you

Answer 14

Active money

+Difference between portfolio weighting of share/sector and index/benchmark weighting
+Loosely, larger active money positions indicate greater divergence from the benchmark and hence more risk relative to benchmark
+Doesn’t provide complete picture of risk versus the benchmark, as some stocks more likely to perform very different to benchmark then others (eg those with high betas)

Information ratio

Ratio of mean of relative divided by standard deviation of relative return

Indicates how efficiently additional risk can be converted into additional return

Question 15

List 5 downside risk measures

Answer 15

Value at risk 
Shortfall probability 
expected shortfall/tail VaR
Downside semi - variance 
Downside semi - standard deviation

Question 16

Define value at risk and state the key assumption that is often made when calculating it

Answer 16

VaR is the maximum potential loss in the portfolio over a specified time period given a certain degree of confidence

It can be calculated in absolute terms or relative to a benchmark

It is usually calculated assuming that returns are normally distributed

Question 17

List five potential difficulties with using value at risk to measure downside risk

Answer 17

+The actual returns of a portfolio are not normally distributed they have fat tails are and sometime skewed
+Difficult to model tails accurately due to a lack of data
+The VaR calculation is highly sensitive to the choice of parameters
+The calculation does not allow for parameter changes due to extreme events
+The calculation is sensitive to the time horizon and degree of confidence

Question 18

Outline the process of stress testing

Answer 18

+Stress testing involves changing the characteristics and assumptions of a portfolio due to the occurrence of an extreme event in order to determine the portfolio sensitivities to predefined risk factors.
+It particularly involves changing the volatilities and correlations of the securities
+It can be done on a portfolio of the portfolio (certain markets) or on the whole portfolio

Question 19

List nine services provided by custodian

Answer 19

Administration of overseas investments
Income collection
Cash management
Tax recovery 
Foreign exchange transactions
Security settlement
Stock lending
Exercise voting rights 
Custody of documents