Chapter 28: Developing and investment strategy (2) Flashcards
Active investment strategy
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.
Passive investment strategy
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.
Historic tracking error
annualised standard deviation of
.. . the difference between actual fund performance and benchmark performance.
Forward-looking tracking error
involves modelling the future experience of the fund based on:
- its CURRENT holdings and
- likely FUTURE volatility and correlations to other holdings.
2 parts of the risk budgeting process
- Decide how to allocate the maximum permitted overall risk between active risk and strategic risk.
- Allocate the active risk budget across the component portfolios (eg to the UK equity manager, to the UK bond manager).
Matching
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.
3 Common problems with the precise matching of assets to liabilities in practice:
- 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.
Stochastic model
Allows for the random nature of some of the model parameters. If the assumptions underlying the model are realistic, then a clearer picture of the appropriateness of the assets is possible.
3 Non-actuarial techniques for determining an investment strategy
- 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.
Liability hedging
Where the assets are chosen in such a way as to perform in the same way as the liabilities.
Immunisation
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.
3 Conditions that must apply, in order for classical immunisation theory (according to Redington) to apply
- The present values of the liability-outgo and asset proceeds are equal.
- The (discounted) mean term of the value of the asset-proceeds must equal the mean term of the value of the liability-outgo
- 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.
8 Theoretical and practical problems with immunisation
- 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
2 (conflicting) objectives of portfolio construction
- reducing risk (often in terms of solvency and stability of cost)
- achieving high long-term returns
3 Types of risk (used in portfolio construction)
- strategic risk
- active risk
- structural risk