Chapter 22: Portfolio management (2)

Question 1

Risks involved in portfolio construction

Answer 1

• Strategic risk
• Active risk
• Structural risk
• Overall risk

Question 2

Strategic risk

Answer 2

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

Question 3

Active risk

Answer 3

Risk taken by the manager relative to their given benchmark

Measured in terms of the tracking error

Question 4

Active return

Answer 4

AKA relative return

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

Question 5

Structural risk

Answer 5

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

Question 6

Overall risk

Answer 6

The sum of the active, strategic and structural risks

Question 7

Multifactor model

Answer 7

Question 8

Use of the multifactor model in active management

Answer 8

Used to estimate the appropriate required return on a share to determine if it is cheap or dear

Question 9

Use of the multifactor model in passive management

Answer 9

Used to identify a suitable portfolio of shares to match liabilities or to replicate an index

Question 10

Quantitative analysis

Answer 10

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

Question 11

Technical analysis

Answer 11

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

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

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

Question 12

Main forms of technical analysis

Answer 12

• charts (chartism)
• mechanical trading rules
• relative strength analysis

Question 13

Chartism

Answer 13

• 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

Question 14

Mechanical trading rules

Answer 14

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

Question 15

Relative strength analysis

Answer 15

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

Question 16

Advantages of technical analysis

Answer 16

• 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.

Question 17

Disadvantages of technical analysis

Answer 17

• 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

Question 18

Risk budgeting

Answer 18

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

Question 19

Risk budgeting process

Answer 19

Define, Choose, Monitor, Rebalance

1. Define a feasible set of asset classes that could be included in the portfolio
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 when necessary due to changes in risk appetite or changes in underlying volatility and correlation data

Question 20

Historical tracking error

Answer 20

AKA retrospective or backwards looking tracking error

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

Question 21

Forward-looking tracking error

And how is it derived?

Answer 21

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

Question 22

Active money

Answer 22

The active money of a position in a particular shareholding is the difference between the shareholding and the benchmark holding in that share.

The sum of the absolute values of the active money can give a cride estimate of the active risk

Question 23

Information ratio

Answer 23

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

Question 24

Downside risk measures and tools to measure downside risk

Answer 24

In addition to downside-semi standard deviation, shortfall probability and the expected shprtfall, commonly used tools to measure downside risk are:

• Value at Risk
• stress testing

Question 25

Shortfall probability

Answer 25

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

Question 26

Expected shortfall

Answer 26

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

Question 27

VaR

Answer 27

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

• Frequently assumes a normal distribution of returns

Question 28

Stress testing

Answer 28

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 the impact of 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

Question 29

Custodian

Answer 29

Holds investments securely on behalf of an investor.

They are usually banks or other regulated institutions.

Question 30

Principal function of a custodian

Answer 30

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

The custodian is thereby able to account independently for any financial transactions

Question 31

Services custodians offer:

Answer 31

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)

Question 32

Global custodian

Answer 32

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