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F105 Finance & Investment > Chapter 22: Portfolio management (2) > Flashcards

Chapter 22: Portfolio management (2) Flashcards

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1
Q

Two conflicting objectives managers face in managing an investment fund established to cover liabilities

A
  1. to ensure security (solvency) and stability of costs which encourages the matching of assets and liabilities
  2. to achieve high long-term investment returns (to reduce cost) which encourages a move away from a matched position into assets expected to generate higher returns
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2
Q

The investment policy needs to reflect the extent to which the risks of lower stability and security are to be taken on to aim for higher returns.

This will typically involve a two-stage process:

A
  1. Establishing the strategic benchmark
  2. 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
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3
Q

Risks involved in portfolio construction

A
  • Strategic risk
  • Active risk
  • Structural risk
  • Overall risk
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4
Q

Strategic risk

A

The risk of poor performance of the strategic benchmark relative to the value of the liabilities

Extent of this risk will depend on the risk appetite and available funds

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5
Q

Active risk

A

Risk taken by the manager relative to their given benchmark

Measured in terms of the tracking error

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6
Q

Active return

A

AKA relative return

The return an active manager achieves relative to their particular strategic benchmark

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7
Q

Structural risk

A

The risk that the aggregate of the individual manager benchmarks does not equal the total benchmark for the fund

Small funds are more exposed to this risk

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8
Q

Overall risk

A

The sum of the active, strategic and structural risks

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9
Q

Multifactor model

A
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10
Q

Use of the multifactor model in active management

A
  • used to estimate the appropriate expected return on a share given a set of risk factors and its estimated factor returns (the coefficients of the risk factors used in the model)
  • thus outperforming shares or sectors can be identified if risk factors are predicted with greater accuracy than the market
  • model used to calculate expected return - can be compared to expected return based on a discounted dividend or PE ratio model
  • If expected return indicated by the multifactor model is lower than indicated by the current share price, the share appears cheap
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11
Q

Use of the multifactor model in passive management

A
  • used to identify and control the exposure of a portfolio to the different risk factors and change the risk profile of the portfolio to better match the exposure of the liabilities
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12
Q

Practical problems with the use of the multifactor model

A

Identifying the factors that affect the expected return on any particular security

Estimating the relationships between those factors and the expected returns. The usual problems associated with time series estimation will all apply here:

  • Random variation
  • The fact that the relationships may change over time
  • Estimates based on past data may not be applicable in the future
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13
Q

Quantitative analysis

A

Use of modern mathematical techniques to aid in stock and sector selection

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14
Q

Technical analysis

A

Estimation of future prices and yields based on the use of past prices, yields and/or trading volumes

Is based on the study of market prices to provide a means of anticipating future prices

Attempt to predict future price movements from the study of market variables like the actual price history and trading volume. Not concerned with fundamental issues such as earnings or dividends

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15
Q

What assets is technical analysis often used for?

A
  • individual securities
  • level of an entire investment market
  • currency values
  • commodities, e.g. gold
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16
Q

Main forms of technical analysis

A
  • charts (chartism)
  • mechanical trading rules
  • relative strength analysis
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17
Q

Chartism

A
  • Examining charts of past market data
  • Try identifying patterns or trends in behaviour of chart of a share price or market index
  • Act on probability that what has tended to follow the trend in the past will be repeated in future
  • Justify approach by linking repeatability of patterns to investor psychology
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18
Q

Mechanical trading rules

A
  • This method removes subjectivity of Chartism
  • Trading signals are given by set price movements
19
Q

Relative strength analysis

A
  • Examines performance of share relative to the market as a whole or its own subsector
20
Q

Relative merits of chartism

A

Disadvantages

  • chartism must be able to identify the pattern before any other chartists to take advatage of the predicted change in price
  • Chartist forced to anticipate patterns before fully formed = competition between chartists may compete the patterns away

Advantages:

  • If identification of significant chart pattern is a matter of judgement chartism may still be useful
21
Q

Advantages of technical analysis

A
  • Easy to collect the necessary data
  • Relatively quick and easy to carry out
  • 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 profits. If correctly predict price movements, can use derivative contracts to make very large profits.
22
Q

Disadvantages of technical analysis

A
  • Relying on technical analysis 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
  • Technical analysis might encourage a more active trading strategy increasing expense levels
23
Q

Risk budgeting

A

Process of establishing how much investment risk should be taken and where it is most efficient to take the risk (in order to maximise return).

It involves:

  • 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 component portfolios
24
Q

How can you test that active management does generate positive returns and what possible problems may arise in doing so?

A

Simplest method would be to compare long-term performance of a selection of actively managed funds against that of a number of index tracker funds

Main problems that arise would be that:

  • Objectives of active and passive managers may be different
  • Different constraints on active managers that affect their performance relative to the trackers
  • Higher amount of risk in active managers’ portfolios
  • Survivorship bias - poor performing active funds would cease to gain new business and be wound up - hence there’s a bias towards active funds that have performed adequately
  • Past performance does not act as a good guide to future performance
25
Q

Risk budgeting process

A

Define, Choose, Monitor, Rebalance

  1. Define a feasible set of asset classes that could be included in the portfolio - obtain careful estimates of volatilities and covariances of each asset class
  2. Choose an initial asset allocation using a risk/return optimisation process and a VaR assessment to determine risk tolerance
  3. Monitor risk exposures and changes in volatilities and correlations
  4. Rebalance the portfolio in response to changes in short term conditional volatility and correlations of the assets. Allocations are altered to keep the overall portfolio risk at the level defined as tolerable for the investor
26
Q

What could choosing the initial asset allocation using some risk/return optimisation process and a VaR assessment to determine risk tolerance involve?

A
  • using asset-liability modelling to determine the matching portfolio
  • performing VaR calculations to determine the total risk budget
  • allocating the total risk budget between strategic risk and total active risk
  • further modelling of investment risks and returns to investigate the different possible investment strategies
  • presenting the results to the client, who would then need to choose between the strategies
  • allocating the total active risk between the different investment managers
  • choosing the investment managers and allocating their benchmarks
27
Q

Historical tracking error

A

AKA retrospective or backwards looking tracking error

Annualised standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance

28
Q

When comparing tracking error of two funds relative to an index should ensure the data is consistent with respect to:

A
  • timescale over which comparison is made
  • number of sub-periods
  • weightings attached to each period
29
Q

Forward-looking tracking error

And how is it derived?

A

Estimated annualised standard deviation of relative returns that the portfolio might experience in the future if its current structure were to remain unaltered

Derived by quantitaive modelling techniques and depends on assumptions including:

  • likely future volatility of individual stocks or markets relative to the benchmark
  • correlation between different stocks and/or markets
30
Q

Active money

A

The deviation from the benchmark portfolio for a specific position is termed the active money of that position in isolation.

Difference between the portfolio holding and the benchmark holding in that share (in percentage)

The sum of the absolute values of the active money positions in each individual holding could be a measure of active risk.

31
Q

Information ratio

A

Ratio between the relative return and the historical tracking error - combines historical risk and historical return relative to a benchmark

Information ratio = mean(relative return) / std dev(relative return)

32
Q

Uses of the information ratio

A
  • Allow us to estimate how efficiently additional risk can be converted into additional return, as part of the risk budgeting process
  • Show that they can out-perform the benchmark (either due to skill or by investing in higher risk securities)
  • Estimate prospective information ratios for different portfolio choices
33
Q

Downside risk measures

A

Involve identifying the worst period under-performances in a specified past period, looking at the frequency with which underperformance has been experienced, or calculating the downward semi-standard deviation (the standard deviations of returns below a certain benchmark)

  • downside semi-variance of returns
  • shortfall probability
  • expected shortfall
34
Q

Shortfall probability

A

Estimated probability that the fund value or surplus falls below a pre-specified benchmark level

35
Q

Expected shortfall

A

Expected amount of the shortfall below the pre-specified benchmark level given that the fund or surplus has fallen below the benchmark level

36
Q

Calculating strategic risk

A

Standard deviation of relative returns (actual returns on strategic benchmark - returns on matching portfolio)

37
Q

VaR

A

VaR assesses the potential losses on a portfolio over a given future time period with a given degree of confidence

  • Can be measured in absolute terms or relative to a benchmark
  • Frequently assumes a normal distribution of returns
38
Q

Stress testing

A

VaR method doesn’t consider the simulataneous increase in asset return volatilities and correlations that’s often observed during extreme market events

Financial stress testing is used to identify and investigate risks incurred by extreme market events

Involves subjecting a 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. This pertains in particular to asset correlations and volatilities

39
Q

Types of stress tests

A

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 gauge the impact of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are “stressed”
40
Q

Custodian

A

Holds investments securely on behalf of an investor.

They are usually banks or other regulated institutions.

41
Q

Principal function of a custodian

A

Ensure financial instruments are housed under proper system that permits investment for proper purposes with proper authority

  • Able to account independently for any financial transactions
42
Q

Services custodians offer:

A

CLIFTS

  • Cash management
  • Stock lending
  • Income collection
  • Foreign exchange trading
  • Tax recovery
  • Securities settlement

+Exercise voting rights on behalf of the manager or trustees
+Has no duty to investigate the propriety of instructions which appear to be in order (unless specific monitoring function has been agreed on)

43
Q

Global custodian

A

A custodian providing international services and assuming responsibility for custody of assets held abroad

  • Where the global custodian doesn’t have a presence in a particular country, it ma appoint a sub-custodian in country concerned who has superior local knowledge/to comply with regulations

F105 Finance & Investment (21 decks)

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