Chapter 22: Portfolio management (2) Flashcards
Risks involved in portfolio construction
- Strategic risk
- Active risk
- Structural risk
- Overall risk
Strategic risk
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
Active risk
Risk taken by the manager relative to their given benchmark
Measured in terms of the tracking error
Active return
AKA relative return
The return an active manager achieves relative to their particular strategic benchmark
Structural risk
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
Overall risk
The sum of the active, strategic and structural risks
Multifactor model
Use of the multifactor model in active management
Used to estimate the appropriate required return on a share to determine if it is cheap or dear
Use of the multifactor model in passive management
Used to identify a suitable portfolio of shares to match liabilities or to replicate an index
Quantitative analysis
Use of modern mathematical techniques to aid in stock and sector selection
Technical analysis
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
Main forms of technical analysis
- charts (chartism)
- mechanical trading rules
- relative strength analysis
Chartism
- 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
Mechanical trading rules
- This method removes subjectivity of Chartism
- Trading signals are given by set price movements
Relative strength analysis
- Examines performance of share relative to the market as a whole or its own subsector
Advantages of technical analysis
- 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.
Disadvantages of technical analysis
- 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
Risk budgeting
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
Risk budgeting process
Define, Choose, Monitor, Rebalance
- Define a feasible set of asset classes that could be included in the portfolio
- Choose an initial asset allocation using a risk/return optimisation process and a VaR assessment to determine risk tolerance
- Monitor risk exposures and changes in volatilities and correlations
- Rebalance the portfolio when necessary due to changes in risk appetite or changes in underlying volatility and correlation data
Historical tracking error
AKA retrospective or backwards looking tracking error
Annualised standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance
Forward-looking tracking error
And how is it derived?
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
Active money
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
Information ratio
Ratio between the relative return and the historical tracking error - combines historical risk and historical return relative to a benchmark
Downside risk measures and tools to measure downside risk
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
Shortfall probability
Estimated probability that the fund value or surplus falls below a pre-specified benchmark level
Expected shortfall
Expected amount of the shortfall below the pre-specified benchmark level given that the fund or surplus has fallen below the benchmark level
VaR
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
Stress testing
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
Custodian
Holds investments securely on behalf of an investor.
They are usually banks or other regulated institutions.
Principal function of a custodian
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
Services custodians offer:
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)
Global custodian
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