Chapter 9: Investment Management Flashcards
Types of risk pt1
- Market/systematic risk = a whole mkt or part of it will rise or fall in certain conditions
- Inaltion risk
- Interest rate risk
- Reinvestment risk = investor cannot invest maturing assets at the same rate as before due to price rises
- Exchange rate risk
- Political/legal risk = changes in law/governance restrict investment
- Regulatory risk = change in regulations restriciting operations
- Default risk
- Liquidity risk = not being able to sell quickly or get the desired price for an investment due to illiquidity.
Quantifying risks
Can provide:
* Forward looking forecasts = predict the liklihood of risks occuring and their impact on the business financially.
* backward looking = looks at previous events and losses and their frequency
Equities risk profile
Considered risky compared to bonds, money mkt instruments. With added risk increases return
Equity risk premium = total return over a period - risk free rate in the same period
Equity total return in 2023= 10% and rfr = 4%, equity risk premium=6%
Money mkts risk profile
Short term, low risk, deliver fixed income but have limited scope for capital growth. High liquidity.
Prices become erratic in times of financial crisis.
Debt instruments risk profile
Attractive to investors due to fixed income provided to investors in a coupon.
exposed to
* interest rate risk
* Default/credit risk.
Overseas equities and bonds risk exposures
- Currency risk - exchange rates might change causing gains/losses on investments that have been bought in a foreign currency to the home currency of the investor
- country risk - risk of political/legal change in the foreign country of investment
Types of investment risk
- Market/systematic risk
- Specific risk = a factor that alters the price of a specific instrument e.g. apple stock after announcing poor earning
- Interest rate risk
- Inflation risk - errodes value of cash/reduces pruchasing power
Diversification and laddering
Diversification by asset: Holding assets that yeild uncorrlated returns. for example cash, bonds, equities and ETFs, derivatives, real estate etc.
Diversification by maturity: aka ‘laddering’ - holding fixed income securities with varying maturity dates. Reduces reinvestment and interest rate risk as the maturity will be spread across a number of different time periods.
Hedging
Buying or selling instruments (usually derivatives) to reduce exposure to mkt fluctuations by taking the opposite position to the position in the portfolio (buy a short when a long is in the portfolio).
Examples are futures, forwards, puts, calls.
Hedging with futures
Futures are cheaper and more efficient than other hedging options and also provide less portfolio disruption.
However the shortfalls are:
* Futures might not be able to immitate the exact risk characteristics of the portfolio position effecitively - e.g. some mkts don’t sell futures or using FTSE to hedge for emerging mkts ETFs doesn’t work.
* Hard to know when to enter/exit the hedge position.
* Operational and regulatory considerations of using futures
Hedging with options - define wasting asset
Purchase put options on long positions which give the right to sell the position at a predefined price if the price falls. This also allows for the investor to benefit from upside gains.
The price of the options contract will increase as the underlying asset price falls
Purchasing put options is an additional expense to fund managers as options charge a premium to buy the contract. This premium is called a ‘wasting asset’. If the fund manager wants to continue to protect the portfolio, they will roll the option onwhich will add further cost.
Despite the additional cost of buying options, the benefit on keeping the overall return of the portfolio positive is preferred. The options premiums are charged against the cash portfolio.
There are additional regulatory considerations with options.
Hedging with contracts for difference (CFDs)
They do not grant ownership of the underlying asset to the CFD holder. The CFD will track the price of the underlying asset so the holder benefits from gains or losses but does not own the underlying asset
CFDs are derivative contracts.
The investor can use leverage to buy these positions as they are margin traded so they can be bought for a fraction of the underlying value.
CFDs provide gains for the investor if the price falls similar to an option and retain a cash position. CFDs are very flexible instruments.
CFD commission charges
CFDs charge comission for each purchase as well as a % of the profit spread and a funding/financing charge. They are subject to a daily financing charge which is usually linked to an index like SOFA.
CFDs are subject to a commission fee on equities that is based on a set % of the size of each trade.
CFD buyers are required to maintain a margin instead of collateral. If the position is leveraged the margins/margin calls can be far greater in times of downturn.
2 types of CFD margin
- Initial = normally between 5-30% of the contract price for stocks and 1% for indicies and FX.
- Variation or maintenance margin = CFD is marked to market and if the position has moved adversely and the initial margin has already been used up the variation margin will be rquested. this is an additional margin.
Company liquidations - capital seniority and liquidation ranking+preference
Liquidation ranking = priority order that the different tiers of owners in teh capital strcuture recieve capital in the event of liquidation
- Debt ranks over equity and there are sub seniorities of debt
- After debt is paid pref shares are paid next - recieveing par value of their shares before any capital is given to ordinary shareholders.
Liquidation preference = amount that needs to be paid to pref shareholders before ordianry shareholders. Expressed as a multiple of the orignal price of the pref shares = 2X liquidity pref on $3 shares means the pref holder will get $6
Debt Seniority
- Senior - first dibs on capital from liquidation
- Subordinated - rank below senior but yields a higher interest for the higher risk
- Mezzanine and payment in kind - more risk than subordinated so offers greater interest. Can be raised in a multitude of ways:
1. Payment in Kind (PIK) notes - have a quoted coupon but the coupon is only paid once the bond matures so the coupon is rolled over for the duration of the bond.
2. Can have convertability clause to give the mex debt holder the right to convert the bond into shares to avoid the firm from paying sucha high IR
Pension funds
- Approved by tax authorities and can accumilate income without capital gains tax.
Divided into 2 mian buckets
* Defined benefit scheme - pays you based on how long you’ve been at the firm and the salary you were on.
* Final salary - pays you your final salary at that firm every year until you kick the bucket.
Life assurance businesses - 4 types
Main types of life assurance business are:
1. Term assurance policies - pay out if the person dies before the end of the set policy in return for a fixed premium.
2. Whole of life policy - pay out of death (regardless of when) in return for a regular premium
3. endowment policy - Term assurance but the payout is related to an underlying portfolio’s performance.
4. Single premium life assurance bonds - single premium instruments with a heavy investment focus similar to teh above.
Can focus on higher risk investments like equities due to long time horizons.
Subject to tax usually.
Usually avoid money market instruments.
General insurance funds and banks - what securities do they prioritise
Both invest in the short term, general insurance for car, home insurance etc and banks with spare cash at the end of a business day.
They both prioritise short term low risk investments in money markets and not in equities.
Regulated mutual funds
Poole investments that can be regulated (authorised) or unregulated (unauthorised). Only regulated funds can be freely marketed whereas unregulated funds can only be marketed to institutional/appropriate investors.
They provide benefits to investors with large amounts of invested capital as they lower the mgmt cost.
Hedge funds
Unregulated/unauthorised investment vehicles that invest in some spicy meatballs like derivatives that link to their strategy.
Can take short positions as well as long and can employ leverage to boost returns.
Referred to as absolute return vehicles as the aim is to provide positive returns to investors regardless of mkt conditions.
Cannot be freely marketed and have limited reporting requirements. Only available to UHNWIs or institutional clients due to high min. investments and lock up periods.
Soverign Wealth Funds - what are they and common objectives
SWFs are govt owned investment funds that are funded from balance of payments surpluses, proceeds from privatisations of once public services, fiscal surpluses and export reciepts.
High risk tolerance with focus on returns over liquidity.
Common SWF objectives:
* Protect/stabilise the budget and economy from excess volatility in revenues/exports
* Diversify from non renewable commodity exports
* Earn greater returns than on FX reserves
* Dissipate unwated liquidity from monetary authorities.
* Increase savings for future use
* Fund social and economic development
* Promote sustianable long term capital growth
Global SWF AuM as of DEC 2022 = $11.3 trillion USD
Requirements for PLCs to share price sensitive info - examples of pips and sips
Listed companies need to share any information with mkt particiapnts that might affect the share price with the public in a timely manner.
Required by the EU transparency directive and companies normally satisfy this by informing a primary information provider (PIP) (an example of a UK PIP is the LSE’s **regulatory news service (RNS) **.
PIPs receive the info and then share it out with secondary information providers (SIPs) like bloomberg, reuters, refinitv etc. This is then distributed to the public and fund managers etc.
Active management of investment portfolios
- Fund manager sets a stratergy that is designed to outperform an equivalent ETF - e.g. long short US large cap fund to make more return than S&P
- Portfolios use more intricate methods of constructing portfolios by doing research, quant analysis and trying to anticipate future macro economic trends
- Only a minority of actively managed funds ever actually outperform their benchmakred indexes
Advantages of actively managed funds
- Allows specific instruments to be selected that are deemed to perform better than the market overall
- Allows for investment in lower risk equities instead of the whole mkt which might have riskier smaller stocks in it.
- The opposite to above - can invest in riskier stocks to try and increase return
- Use specific hedges
- Can focus on specific industries in a market
Disadvantages of active management
- Bad investment choices from the manager can hurt returns
- High fees
- Transaction costs from regular trading diminish returns as well as capital gains tax when selling positions
- When funds become too big they hold a lot of securities and begin to act and provide returns similar to that of indexes - making them poor value for money
- After funds reach a certain size they have to diversify to reduce risk which can in turn see them stray away from their original stratergy
Active management with manager participantion
Term given to funds when the directors/SMOs have capital invested into the fund. that the manager is running. This is common in PE funds and hedge funds.
As the manager has capital invested in the fund they will think with investors in mind to deliver return as they have ‘skin in the game’
Active bond stratergies - leveraging underpriced bonds
Active management stratergies can be used when bonds are considered mispriced to capitalise on this.
It involves buying/selling over and underpriced bonds to try and outperform a buy and hold passive policy.
the success of the approach is partly based on whether the target bonds are actively tradded on the secondary market and if they are accurately priced.
3 types of bond switching and mkt timing
- Anomoly switching - Involves moving between 2 similar bonds that have different trade prices and yields. It is exploited when teh manager switches to the lower priced bond over the higher priced bond to benefit from better value for money gains.
- Policy switching - when an IR cut is expected but not yet shown on the yield curve low duration bonds become volatile whch can provide gains if this is pre-empted
- Inter-market spread switch - switching between corporate and govt bonds based on the risk appetite of the wider market of investors to capitalise on changing yeilds
Market timing = when active mgmt is employed as it is believed the markets view of the yield curve is inaccurate/failed. ‘riding’ the yield curve takes advantage of the upward sloping yield curve
Advantages of passive mgmt
- Performance depends on the mkt and not the skill of the inv. manager.
- Investors are really only exposed to systematic risk and void other risks associated with active mgmt. However some gains are forgone here as well
- Tend to outperfom active mgmt funds
- avoid large mgmt fees and other cap gains tax from regular trading = far better total expense ratio
- Introduction of smart beta ETFs that are specialist investment vehicles that can use alternative portfolio construction methods based on profitability, cash flow etc. These provide exposure to specific securities in the form of an ETF with tiny mgmt fees
Disadvantages of passive mgmt
- Returns are linked to an index so the investor must be satisified that the retuns from that index are enough
- Passive stratergies mean that no hedging measures are incorporated into the fund.
- IF the makret goes down then the investor will suffer losses as passive funds track the mkt.
- The main disadvantage is that passive funds cannot generate alpha (returns greater than that of the benchmark)
- Certain mkt industries might be more efficient or profitable than others so the less profitable ones will drag down the overall return.
- No ability ot adjust risk by hand picking lower/higher risk stocks to suit returns and risk appetite
- Investors might want funds with higher weightings in certain industries. e.g. someone works in finance and has comp tied up in stock, then it makes sense to diversify out of the fin svs industry.
- Some mkts cannot access index trackers
Smart Beta and beta - what does beat of over 1 mean
- Beta is the measure of a security’s volatility compared to an index. A replication tracker ETF will have a beta of 1. Betas more than 1 are more volatile. However, using mkt cap to weight an index means overvalued stocks make up a greater % than the undervalued ones.
- Smart beta = uses an alternative weighting system for an index (e.g. dividends paid, sales revenue etc). it combines the main advantage of passvie mgmt (low costs) with the advantage of active mgmt as it allows for potential outperformance of the index.
Passive funds. -Hedge fund replication and factor investing
They both mimic the stratergies of specific hedge funds or gain exposure to cheaper, smaller companies using a systematic approach.
attempt to provide outperformance with lower costs than active mgmt and with greater transparency
Passive bond stratergies - immunisation, barbell stratergy, ladder portfolio
- Used when the market is deemed efficient or when a bond portfolio is constructed simply to meet a future fixed liability.
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Immunisation is used when there is a future fixed liability to pay = portfolio is protected from interest rate changes. 2 types of immunisation:
1. cash matching = portfolio constructed of bonds with coupons and redemption payments are alligned to the liabilities that need to be met.
2. Duration based immunisation = portfolio is constructed with the same intitial value as the present value of the liability and designed to meet the same duration = AKA bullet portfolio. - Barbell stratergy = holds bonds for a fixed liability but uses bonds with maturity + coupon dates as close as possible to the liability date. Need regular rebalancing compared to bullet portfolios. e.g 10 year liability - holds 5 and 15 year to maturity bonds.
- ladder portfolio = constructed with equal weighting of bonds with different duration/maturity dates. e.g holds bonds in 1,2, etc, 20 year notes to meet a 10 year liability.
Mgmt stratergy and efficient mkts hypothesis
- EMH theory that states it is impossible to beat the market as mkt efficiency is always priced into exisiting stocks. This means that prices are always valued fairly and over/under pricing doesn’t exist. Therefore outperforming the mkt is impossible and you have to increase risk to get greater returns
- EMH links to passive investing rationale
- Strong EMH = the view it is out right impossible to beat the mkt long term.
- Weak EMH = the differences of spread of infirmation can create advantages for people to profit from.
ESG investing
= the level ESG is considered when investing and managing a portfolio
* ESG AKA = Responsible investing (RI), social RI, impact inv and sustainable inv.
* ESG typically sets max exposure that a portfolio has to a specific industry/non ESG factor.
*
ESG factor examples by environmental, social, governance
Environment
* Enegry use and conservation
* Carbon footprint, waste minimisation
* conservation efforts
* view on and efforts to manage climate change
Social
* support for local community
* charity work
* company values
* health and safety standards
Governance
* diversity of the board
* Balance of exec directors and non execs
* transparency with reporting
* ethical expactations of staff
The united nations principles for responsible investment (PRI)
PRI is a non profit organisation that encourages investors to manage risk and invest sustainably
* 2006 - published 6 principles that investors, IMs and fin svs providers signed:
1. incorporate ESG into inv. analysis
2. Active ownership - incorporate ESG into ownership policies
3. disclose appropriate ESG issues
4. promote adoption of the 6 principles in the wider inv industry
5. collaborate to enhance effectiveness in implementing the principles
6. report on activities and progress towards implementing the principles
Financial stability board (FSB) and the task force on climate related financial disclosures (TCFD) - 4 areas for firms to focus
G20 countries asked the FSB to create a list of recommendations for more climate effective investing. They created the TCFD.
2017 - TCFD publish 4 areas to assist companies implementing climate related fin disclosure:
1. GOvernance disclosure - corp’s governance policies around climate related risk
2. Stratergy disclosure - actual+potential imapcts of climate risk and opportunities on the corp’s business
3. Risk mgmt disclosure - how the corp identifies, assess, manages climate risks
4. Metrics and targets disclosure - metrics and targets to manage cimate risks
ESG Spectrum of investing - 5 levels
5 levels go in order on how committed an investor is to meeting ESG. A lot of corps adopt the fully delegated approach however investors will want to focus more on ESG factors so will look for a integrated approach.
1. Fully delegated - delegates ESG to inv. manager’s personal ESG policies
2. values based ethical inv. - avoides controversial sectors like tobacco, defense
3. sustainable investing, integrated approach - manage esg risk to seek + ESG outcomes
4. impact investing - investing in companies or funds that provide solutions to social and environmental issues whilst trying to provide returns.
5. impact only/philanthropic inv. - no priority on returns all focus on ESG
Advantages fo ESG
- Better returns - studies revealed investing with an ESG focus yields higher than without.
- lower risk - ESG funds have shown lower downside risk compared to traditional funds
- reflect changing investor attitudes - attracts more investors as the general population want more ESG focussed investment.
Disadvantages of ESG
- Ethics cloud judgement - focus on ESG instead of making profit - bad idea, lose investors
- More research required - adds additional research requirements which is time consuming and expensive.
- Greenwashing - funds/corps pretend to be environmentally friendly but actually don’t give a fuck.
DONE SUIIIIIIIIIIIIIIIIIIIIII
