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
Strategic risk
the risk that the strategic benchmark does not match the liabilities
Active risk
The risk taken by the individual investment managers relative to the given benchmarks
Structural risk
where the aggregate of the individual investment manager benchmarks does not equal the total benchmark for the fund.
4 Actuarial techniques for determining an investment strategy
- Pure/exact matching
- Liability hedging:
….• Full Hedging
….• Approximate hedging (immunisation) - Asset liability models
- Mean-variance with reference to liabilities
Pure matching
- Asset proceeds coincides precisely with net liability outgo
- Sensitivity of timing & amounts need to be known with certainty
2 Restrictions of pure matching
- Rarely possible in practice (except for fixed liabilities)
- Suitable assets might not be available / prohibitively expensive
Its still useful as a benchmark position though
Full hedging / matching
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, ect.
Full hedging / matching in practice
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
Approximate hedging / matching
Hedging with regards to specific factors:
- Nature (fixed/real)
- Term
- Currency
- Immunisation (interest rates)
Asset-liability models
- measures risk of not meeting investment objectives
- allows for variation in assets and liabilities simultaneously
- Usually a stochastc model
- Enables comparison of projected asset proceeds / liability outgo under different strategies to find the optimum strategy
- Encourages investors to formulate explicit objectives.
Mean-variance portfolio theory with liabilities
- 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
Role of an “investment” actuary
An “investment” actuary is used to recommend and monitor:
- The overall investment strategy
- The portfolio “design” or “structure”
- The asset managers
3 Sources of profit for active investment managers
- Asset class selection profits
- Sector selection profits
- Stock selection profits
Active money
- Deviation from benchmark portfolio for specific position
- The closer to zero, the more passive the fund
Risk Budgeting
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
Asset-liability model
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.
Workings of an asset-liability model
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.
Advantage of an asset-liability model
It encourages investors to formulate explicit objectives.
Asset-liability model:
The investment objectives should include (3)
- A quantifiable and measurable performance target
- defined performance horizons
- quantified confidence levels for achieving the target
Commercial matching
Instead of tracking the index, the aim is to match the performance of your competitors.
Immunisation:
Rebalancing must be done to maintain the correct balance of: (2)
- equal discounted mean term
- greater spread of asset proceeds
The 2-stage process of achieving investment objectives
- Establishing an appropriate asset mix for the fund. - the STRATEGIC BENCHMARK
- 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.
Overall risk
The "sum" of the - active, - strategic, - and structural risks.
Active money position
The difference between the actual position and the benchmark portfolio.
