Chapter 28: Developing an investment strategy II

Question 1

What is active investment management?

Answer 1

an active investment manager attempts to use judgement to make extra returns by carrying out tactical switches.

an active manager has few constraints on the choice of assets.

Question 2

What is passive investment management?

Answer 2

the holding of assets that closely reflect those underlying a certain index, or specific benchmark.
There is little freedom to choose investments.

However the strategy is not risk free, since:

• the index or benchmark may perform badly
• it may not be possible to exactly match the index/benchmark, which introduces TRACKING ERROR

Question 3

Which approach (active/passive) will give higher returns?

Answer 3

It depends.

An active approach might be expected to produce greater returns due to stock selection profits, but there will be higher investment management expenses.

Note: in an efficient market, there are no extra benefits from active management.

Question 4

Describe how to measure active risk

Answer 4

Active risk can be measured using the historic / backwards-looking tracking error.

This is the annualised standard deviation of the difference between the portfolio return and the benchmark return, based on observed relative performance.

An alternative is to use the forward-looking tracking error.

This is an estimate of the standard deviation of returns relative to the benchmark, that the portfolio might experience in the future.

Question 5

2 Conflicting objectives faced by an investment fund established to cover liabilities

Answer 5

• to ensure security (to meet liabilities)

- to achieve high, long-term investment returns

Question 6

4 categories of risk faced by an investment fund

Answer 6

• strategic risk
• structural risk
• active risk

Question 7

Strategic risk

Answer 7

The risk of underperformance if the strategic benchmark does not match the liabilities

Question 8

Structural risk

Answer 8

The risk of underperformance if the sum of the individual benchmarks given to fund managers does not add up to the strategic benchmark.

Question 9

Active risk

Answer 9

The risk of underperformance if the fund managers do not invest exactly in line with the individual benchmarks that they are given

Question 10

Risk budgeting

Answer 10

the process of establishing how much risk should be taken, and where it is most efficient to take the risk in order to maximise returns.

Assets are then chosen to give this risk profile.

Question 11

With regards to investment risks, the risk budgeting process has two parts:

Answer 11

1. Deciding how to allocate the maximum overall risk between strategic, structural and active risk.
2. Allocating the total fund active risk budget across the component portfolios. E.g. how much risk can the equity manager take and how much risk can the bond manager take

Question 12

Pure matching

Answer 12

Choosing assets so that the timing and amount of the asset proceeds coincide exactly with the timing and amount of liability outgo in all circumstances.

Question 13

Why not just use zero coupon bonds to match fixed liabilities?

Answer 13

• they are not always available at the right terms

- they tend to be expensive, as everyone wants them for matching

Question 14

Asset-liability model

Answer 14

Specifies an objective that refers to both the assets and the liabilities. E.g. Assets - liabilities must be greater than zero over the next 10 years.

The objective should contain both a measurable target, and a time period. If the model is stochastic, it should also contain a probability confidence interval.

An asset-liability model examines a particular investment strategy by projecting forward asset and liability cashflows and valuing them.
The model should be dynamic. I.e. the interaction/correlation between the assets/liabilities should be allowed for.

The results of a particular model run is compared with the objective. If the objective is not met, then the investment strategy is adjusted and the model run again until the objective is met.

Question 15

Difference between a deterministic and stochastic model

Answer 15

A deterministic model is based on a set of specific assumptions of the future. These can be varied using specific scenarios of the future using scenario testing.

A stochastic model treats some of the assumptions (eg investment returns / inflation) as random variables. The model is run several times, each time simulating a different value of the stochastically modelled variables. A distribution of outcomes is produced.

Question 16

3 Non-actuarial techniques for determining investment strategy

Answer 16

• mean-variance portfolio theory without reference to the liabilities
• index tracking
• matching competitors

Question 17

Liability hedging

Answer 17

where the assets are chosen in such a way as to perform in the same way as the liabilities.

Liability hedging aims to select assets that perform exactly like the liabilities in all states. This is usually not achievable in practice.

In practice, the investor might try to hedge liabilities with respect to specific factors. E.g. immunisation.

Question 18

Immunisation

Answer 18

involves choosing assets so that the PV(assets) - PV(liabilities) is immune to a general small change in the rate of interest.

Question 19

3 Conditions that need to hold for classical immunisation theory

Answer 19

• Present value, and
• Discounted mean term
  of the liability outgo’s and asset proceeds are equal
• the convexity of the assets is greater than that of the liabilities

Question 20

Practical problems with immunisation

Answer 20

• generally aimed at meeting fixed liabilities, although it can be applied to index-linked liabilities if index-linked bonds exist
• by immunising the possibility of mismatching profits as well as losses is removed, apart from a small second-order effect
• the theory only works for a small change in interest rate
• assumes a flat yield curve
• assumes level interest rate changes at all terms
• In practice the portfolio would need to be rearranged constantly so that the 3 inititial conditions stay met.
• Dealing costs and tax are ignored.
• Assets of a suitably long discounted mean term may not exist.
• The timing of asset proceeds and liability outgo may not be known.