Chapter 6 - Investment Portfolio Management Flashcards
Top down asset management
1) determine asset allocation
2) allocate geographical spread
3) choose stocks taking into account any preferences
what is tactical asset allocation?
involves the short-term variation of the asset allocation of the fund (within pre-defined ranges) in order to take advantage of market changes or fluctuations.
Explain strategic and tactical asset allocation and how it may be used in the management of a portfolio
Strategic
• Focuses on long term goals.
• Established at the outset.
• Then rebalanced to maintain asset splits.
• It is based on client’s objectives and ATR.
Tactical
• Is short term, using ad hoc or short term adjustments.
• Allows fund manager to take advantage of opportunities in the market.
• With a view to beat the benchmark by deviating from the strategic asset split.
what is the pragmatic approach
- simply compares each asset class’s long-term performance.
- less technical
- simply states that history will repeat itself in the future if given enough time.
Limitations of optimisation models
•Optimisation models assume that distributions are normal and therefore can be measured by Standard Deviation.
•Distributions, however, are rarely ‘normally distributed’.
• Based on historic performance
•The models may assume that re-balancing occurs frequently.
•Re-balancing adds trading costs that may affect overall performance, so may be infrequently carried out.
Difference between fundamental and technical analysis
Fundamental focuses on a company’s intrinsic value by examining its financial health, industry trends, and economic factors to determine if a stock is undervalued or overvalued,
technical analysis analyzes historical price and volume patterns on charts to predict future price movements, typically used for shorter-term trading strategies
what is active management?
- Active management is an investment strategy using analysis, in an attempt to achieve above average or superior risk-adjusted returns.
- It encompasses many different styles and strategies, aiming to produce greater returns than those of the index, against which the portfolio is benchmarked. It uses fundamental analysis, technical analysis, and
macroeconomic analysis.
Advantages of active management
• Informed investment decisions based on
experience, judgement and analysis of
market trends and prospects.
• The possibility of higher returns than the
index against which the portfolio is
benchmarked.
• The ability to take defensive measures if
managers expect the market to take a
downturn by moving into defensive
sectors or hedging the portfolio.
Disadvantages of active management
• Higher fees and operating expenses.
• Market, sector and stock analysis may not
produce the right selections and the portfolio
could underperform its benchmark index.
• The investment style adopted may adversely
impact performance and reduce returns as it
may not be in favour with the market.
What is value?
• The oldest style.
• The fund manager believes that you can get undervalued shares if you look hard
enough and find out enough about the company.
• They ‘find’ these, buy them and keep them, often for long time periods.
• Often termed buy and hold strategies.
• Often adopted by equity income or income and growth fund managers.
What is GAARP
• GAARP is based on finding firms with long term growth prospects and buying
them if they aren’t too expensive.
• Traditional companies are often sought that have proven long term records.
• These often trade at a premium, but they are bought on the assumption that this
is a price worth paying.
• They are then usually held long-term.
• Often adopted by active growth managers.
what is momentum?
• This approach is reacting to investor sentiment and seeking to ‘get on the band
wagon’ of fashion trends.
• Can involve sector rotation.
• Often adopted by middle-of-the-road fund managers.
what is contrarianism?
• Based on the theory that most analysis is wrong so, rather than following a
trend; go against it!
• Goes against standard thinking i.e. ‘sheep or herding’ mentality.
• Often used by hedge fund managers.
Explain what is meant by the term rebalancing and why it is practiced
Rebalancing and why practiced
• It is the buying or selling of assets within a portfolio to rearrange assets,
• To ensure that the agreed asset allocation is complied with.
• It is used when the performance of different asset classes,
• Has resulted in a difference to the agreed allocation over time.
• The rebalancing brings the fund back in line with the clients ATR and objectives.
Outline five possible drawbacks of rebalancing a portfolio (5 marks)
Drawbacks of rebalancing
• Those assets that have performed well are usually the ones that are sold.
• These may be the assets that would have continued to outperform and produce higher returns for the portfolio overall.
• The assets bought may be those that will continue to fall in value.
• There will be charges involved in the buying and selling of the assets.
• The sale may result in a tax liability for the client.
• The market conditions could mean that the timing of the sales or purchases is not ideal.
Explain what is meant by momentum investing
• Momentum investing is looking for a trend, and following it.
• There is the hope that this trend will continue in its current direction and a purchase will benefit
from this.
• It is then looking to sell before the trend reverses.
Identify three potential disadvantages of momentum investing
• Trends can reverse rapidly and without warning, and the investment may have been made too late to capitalise on any further rise in the market.
• The stocks purchased may not align with other objectives, such as the need to provide income.
• There could be high transaction costs, as the holding period is often short.
• It ignores more fundamental analysis of the companies involved or other factors
Pros of passive management
•Costs are low when compared to active managed funds, due to lower management and trading costs.
•Few fund managers actually ‘beat’ the index in developed markets.
•Where fund managers do ‘beat’ the index it is often by taking higher risks.
•Performance is easy to follow, as it is in line with the index.
•No reliance on the investment management ability of the fund manager.
Cons of passive investment
•You follow the market, which can be a rollercoaster at times.
•You can never ‘beat’ the index, as you are simply tracking it.
•In fact, you will always underperform the market, as the fund will inevitably have some charges attached (albeit low charges), called a tracking error.
•With performance dictated by the index, investors must be satisfied with average returns.
•Fund managers can’t move out of sectors or stocks that may be about to decline, or use hedging.
•Mergers can distort the index
what causes tracking error?
• There may be fewer stocks in the portfolio than in the index to keep trading costs down.
• The timings of payments can create a drag on performance.
• Some indices are more difficult to track than others, particularly bond indices, due to the liquidity issues that occur when bonds other than government bonds are used, and so different calculation methods are used and can create errors.
• Indices can be dominated by a number of large stock that can be difficult to replicate within the fund, so adjustments have to be made.
what is full replication?
This is where the fund fully replicates the index it is tracking (if the fund is large enough).
The fund actually owns the shares in proportion to the index. If the fund is smaller this may not be possible
what is stratified sampling?
This is where a fund uses stratification, whereby the fund holds a sample of the funds within an index, as it does not have sufficient assets for full replication.
what is optimisation?
This is where the fund basically buys and sells stocks in an index using a computerised model. The fund is not looking to track all the selected weightings but a selection, through a computer
model.
What is synthetic replication?
This is often used in ETFs, it involves the fund manager entering a SWAP, which is an over-the- counter derivative, that exchanges return on the index for a payment. The advantage of this method is that it is generally a lower cost method that passes the risk of a tracking error over to the
counterparty of the SWAP. This counterparty risk however would need to be managed.
what is core-satellite strategy?
With core-satellite strategies, you could have a core, for example 80% of the fund indexed to minimise the risk of underperformance.
Then the remainder could be invested in a number of specialist actively
managed funds, or individual securities, known as satellites.
what is hard protection?
•The investment is linked to a stockmarket e.g. the FTSE 100 index.
•If the index falls, then the capital is returned but if it rises then the gains up to a cap are
paid to the investor.
what is soft protection?
•Similar to above, but the capital is at risk if a threshold condition is breached.
•E.g. 5% annual income will be paid and capital will be returned, provided the index does not fall by more than 20%.
Different types of MSCI Index
- MSCI PIMFA Private investor income index.
• MSCI PIMFA Private investor growth index.
• MSCI PIMFA Private investor conservative index.
• MSCI PIMFA Private investor balanced index.
• MSCI PIMFA Private investor global growth index.
what are benchmarks used for?
Benchmarks are used to:
• monitor market performance.
• compare the performance of a particular share with its sector or with the market as a whole;
• compare the performance of a fund manager with the performance of the market as a whole;
• measure systematic risk (beta).
what is tactical asset allocation
- involves the short-term variation of the asset allocation of the fund (within
pre-defined ranges) in order to take advantage of market changes or
fluctuations. - Investment managers seek to counterbalance the defensive tendencies of asset allocation methodology by applying tactical asset allocation.
- More often than not, tactical asset allocation models are present in discretionary managed portfolios rather
than advisory ones.
Explain how the FTSE 100 is composed.
• It consists of the largest 100 companies.
• Weighted by market capitalisation.
• That are listed in the UK expressed in sterling
• The companies meet the listing rules and include just the tradeable shares known as the free float.
• The list of companies is reviewed on a quarterly basis and updated as necessary.
Explain briefly the limitations of using the FTSE 100 as a benchmark for a portfolio
• The FTSE 100 index takes no account of charges or tax considerations.
• The FTSE 100 does not reflect any dividend pay-outs.
• Large companies can affect the overall index disproportionately.
• Unless the portfolio contains the actual shares of the FTSE 100, the portfolio and index may not
align.
Explain four different methods a FTSE 100 tracker could use to mirror the index
performance
Full Replication
• Holds each constituent of the index.
• In accordance with its index weighting.
Stratified sampling
• Representative sample of stocks held.
• From each sector.
Optimisation
• Uses a computer model or algorithms to determine an optimum holding.
Synthetic
• Uses a market counterparty,
• To enter an over-the-counter contract such as a swap or other derivative.
Explain five advantages and five disadvantages of selling direct shares to invest in a FTSE 100 tracker
- There is less involvement and administration involved.
• There is likely to be more diversification, as the tracker will now be following 100 shares rather
than a few directly held ones.
• The tracker will reduce non-systematic or company specific risks taken.
• It is easier to monitor performance as FTSE data is easily available.
• Changes can be made to the tracker without CGT penalty.
Disadvantages of FTSE tracker vs direct shares
• There is less control over the companies held, as investor wouldn’t have a vote at an AGM
• The sale of the direct shares could result in a Capital Gains Tax liability.
• There would be selling costs to realise the value of the existing shares.
• A tracker is unable to outperform the index it is tracking.
• There will be ongoing charges for the tracker fund.
5-step process for performance
attribution:
- Select appropriate benchmark.
- Confirm benchmark asset allocation.
- Analyse benchmark returns.
- Compare benchmark asset allocation to portfolio asset allocation and see how
portfolio would have done using benchmark asset returns - Stock-selection and / or sector-choice, to see how the manager’s selection of
investments within each asset class performed, relative to an appropriate index.
what is n investment policy statement
The IPS…
• outlines the general investment goals and objectives of a client.
• describes the strategies that the manager should employ to meet these objectives.
• includes specific information on matters such as asset allocation, risk tolerance, and liquidity
requirements.
what is Sequencing risk
o This is a problem that affects the value of an investment portfolio from the order (or
sequence) in which investment returns occur.
o Negative returns that happen early can have a greater effect than negative returns that
happen after periods of growth.
o This is due to the fact that the value of the fund once initially impacted is less able to make
up the growth later.
