Chapter 28: Developing and investment strategy (2)

Question 1

Active investment strategy

Answer 1

The investment manager has
- few restrictions on investment choice within a broad remit.

This method is expected to produce greater returns despite extra dealing costs and risks of poor judgement.

Question 2

Passive investment strategy

Answer 2

Involves holding assets closely reflecting those underlying an index or specified benchmark.

The investment manager has little freedom of choice.

There remains the risk of

• tracking errors
• a poorly performing index / benchmark.

Question 3

Historic tracking error

Answer 3

annualised standard deviation of

.. . the difference between actual fund performance and benchmark performance.

Question 4

Forward-looking tracking error calculation:

Answer 4

involves modelling the future experience of the fund based on:

• its CURRENT holdings and
• likely FUTURE volatility and correlations to other holdings.

Question 5

2 parts of the risk budgeting process

Answer 5

1. Decide how to allocate the maximum permitted overall risk between active risk and strategic risk.
2. Allocate the active risk budget across the component portfolios (eg to the UK equity manager, to the UK bond manager).

Question 6

Matching

Answer 6

Involves structuring the flow of income and maturity proceeds from the assets so that they will coincide precisely with the outgo in respect of the liabilities under all circumstances.

Question 7

3 Common problems with the precise matching of assets to liabilities in practice:

Answer 7

• uncertain in the timing and/or amounts of either assets or liabilities
• assets of long enough term may not exist
• income from the assets may exceed liability outgo in the early years.

Question 8

Stochastic model

Answer 8

• Allows for the random nature of some of the model parameters.
• If the assumptions underlying the model are realistic, then its possible to see more clearly the appropriateness of the assets chosen.

Question 9

3 Non-actuarial techniques for determining an investment strategy

Answer 9

• mean-variance optimisation without reference to the liabilities
• basing asset allocations on market capitalisations, ie index-tracking
• shadowing the strategies of other comparable institutional investors.

Question 10

Liability hedging

Answer 10

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

Question 11

Immunisation

Answer 11

The investment of the assets in such a way that the present value of the assets minus the present value of the liabilities is immune to a general small change in the rate of interest.

Question 12

3 Conditions that must apply, in order for classical immunisation theory (according to Redington) to apply

Answer 12

1. The present values of the liability-outgo and asset proceeds are equal.
2. The (discounted) mean term of the value of the asset-proceeds must equal the mean term of the value of the liability-outgo
3. The spread (or convexity) about the mean term of the value of the asset-proceeds should be greater than the spread of the value of the liability-outgo.

Question 13

8 Theoretical and practical problems with immunisation

Answer 13

• immunisation is generally aimed at meeting fixed monetary liabilities
• immunisation removes mismatching profits apart from a second-order effect
• the theory relies upon small changes in interest rates
• the theory assumes a flat yield curve and level interest rate changes at all times
• in practice, the portfolio must be constantly rebalanced
• the theory ignores dealing costs
• Assets of a suitably long discounted mean term may not exist
• the timing of asset proceeds and liability outgo may not be known

Question 14

2 (conflicting) objectives of portfolio construction

Answer 14

• reducing risk (often in terms of solvency and stability of cost)
• achieving high long-term returns

Question 15

3 Types of risk (used in portfolio construction)

Answer 15

• strategic risk
• active risk
• structural risk

Question 16

Strategic risk

Answer 16

the risk that the strategic benchmark does not match the liabilities

Question 17

Active risk

Answer 17

The risk taken by the individual investment managers relative to the given benchmarks

Question 18

Structural risk

Answer 18

where the aggregate of the individual investment manager benchmarks does not equal the total benchmark for the fund.

Question 19

4 Actuarial techniques for determining an investment strategy

Answer 19

• Pure/exact matching
• Liability hedging:
  ….• Full Hedging
  ….• Approximate hedging (immunisation)
• Asset liability models
• Mean-variance with reference to liabilities

Question 20

Pure matching

Answer 20

• Asset proceeds coincides precisely with net liability outgo
• Sensitivity of timing & amounts need to be known with certainty

Question 21

2 Restrictions of pure matching

Answer 21

• Rarely possible in practice (except for fixed liabilities)
• Suitable assets might not be available / prohibitively expensive

Its still useful as a benchmark position though

Question 22

Liability hedging / matching

Answer 22

Liabilities ‘behave’ (in terms of values, returns, CFs) in the same way as assets with regards to all relevant factors, eg:

• interest rates,
• inflation,
• currency,
• decrements, etc.

Question 23

Full hedging in practice

Answer 23

In practice its achievable in limited circumstances (E.g. unit-linked liabilities):

• Unit price is determined by reference to the portfolio
• Can be difficult if benchmark is determined externally
• Derivatives are extensively used

Question 24

Approximate hedging / matching

Answer 24

Hedging with regards to specific factors:

• Nature (fixed/real)
• Term
• Currency
• Immunisation (interest rates)

Question 25

Asset-liability models

Answer 25

• Usually a stochastic model
• allows for variation in assets and liabilities simultaneously (DYNAMIC MODEL)
• Encourages investors to formulate explicit objectives.
• Measures risk of not meeting investment objectives
• Enables comparison of projected asset proceeds / liability outgo under different strategies to find the optimum strategy

Question 26

Mean-variance portfolio theory with liabilities

Answer 26

• Extend portfolio theory to take account of investor’s liabilities
• Consider size of surplus (“S = A-L”) at the end of a single period
• Use mean-variance theory to minimize the variance of surplus for the given expected return

Question 27

Role of an “investment” actuary

Answer 27

An “investment” actuary is used to recommend and monitor:

• The overall investment strategy
• The portfolio “design” or “structure”
• The asset managers

Question 28

3 Sources of profit for active investment managers

Answer 28

• Asset class selection profits
• Sector selection profits
• Stock selection profits

Question 29

Active money

Answer 29

• Deviation from benchmark portfolio for specific position

- The closer to zero, the more passive the fund

Question 30

Risk Budgeting

Answer 30

The process of setting risk limits.

Setting an overall risk limit…
then deciding how to allocate the overall risk limit:
… across all the activities / sources that give rise to investment risk
… in order to maximise overall return
… within the overall risk limit

Question 31

Asset-liability model

Answer 31

An asset-liability model is a tool used by an investor to help determine what assets to invest in given a particular objective or objectives.

Question 32

Workings of an asset-liability model

Answer 32

The outcome of a particular investment strategy is examined with the model and compared with the investment objectives.

The investment strategy is adjusted in the light of the results obtained and the process is repeated until the optimum strategy is reached.

Question 33

Advantage of an asset-liability model

Answer 33

It encourages investors to formulate explicit objectives.

Question 34

Asset-liability model:

The investment objectives should include (3)

Answer 34

• A quantifiable and measurable performance target
• defined performance horizons
• quantified confidence levels for achieving the target

Question 35

Commercial matching

Answer 35

Instead of tracking the index, the aim is to match the performance of your competitors.

Question 36

Immunisation:

Rebalancing must be done to maintain the correct balance of: (2)

Answer 36

• equal discounted mean term

- greater spread of asset proceeds

Question 37

The 2-stage process of achieving investment objectives

Answer 37

1. Establishing an appropriate asset mix for the fund. - the STRATEGIC BENCHMARK
2. The strategy can be implemented 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.

Question 38

Overall risk

Answer 38

The "sum" of the 
- active, 
- strategic, 
- and structural 
risks.

Question 39

Active money position

Answer 39

The difference between the actual position and the benchmark portfolio.