Chp 25-28 Flashcards
1) Different ways of expressing investment objectives
i) Meet liability as they fall due
ii) Control incidence of future obligations on third party
1) Different ways of expressing risk
i) Probability of particular investment failing completely
ii) Expected variability of return from investment
iii) Risk of failing to achieve investor’s objective
iv) Risk of underperforming compared to competitors
3) Influences on institutional investors’ preferences for income vs. growth (e.g. dividends vs. capital growth), and volatility
a) Tax – prefer to receive as much of total return as possible in lower taxed form
b) Cashflow – if requirements low, prefer low income yielding investments to avoid expense and uncertainty of reinvesting income
c) Volatility disliked by investors where solvency needs to be demonstrated regularly
4) Factors to consider before making a tactical investment switch
a) Extra returns to be made relative to additional risk
b) Constraints on the changes that can be made to the portfolio
c) Expenses of making the switch
d) Problems of switching a large portfolio of assets
5) Investor characteristics (Acronym – TRAITOR)
Tax status
Regulation/solvency requirements
Assets already held (diversification)
Income vs. capital gains (consider cashflow situation)
Tastes = preferences = liabilities, education expertise, tax fashion
Other investors (competitors) and Other investments (alternatives) and Objective
Risk appetite
6) Factors affecting investment strategy of individual investors
a) Similar to factors for institutional investors
b) Extras to consider – expected future income, major expenditure such as house purchase, real liabilities, real income during working ages but fixed income (pension) during retirement, liabilities usually domestic and hence local currency, investment strategy differs for before and after retirement, investing for long term may not be concerned about short-term variations, tax situation
7) Influences on investor’s preferences for income vs. growth, and volatility
Tax status
Regulation/solvency requirements
Assets already held (diversification)
Income vs. capital gains (consider cashflow situation)
Tastes = preferences = liabilities, education expertise, tax fashion
Other investors (competitors) and Other investments (alternatives) and Objective
Risk appetite
8) Practical constraints suffered by individual investors
a) Constrained in investment choice – by size of liabilities relative to assets, may often not be in a position to accept very much risk
b) Uncertainty – Can lose much of income such as redundancy or ill health, unexpected expenditure can occur, need to keep some assets in a reasonably liquid form
c) Not enough assets for direct investment in some asset classes
d) High relative expenses when investing small amounts
e) Lack of information and/or expertise
9) Pros of collective investment schemes for an individual investor
i) Investment expertise
ii) Able to invest in asset classes that are otherwise not available
iii) There may be tax advantages
iv) Greater diversification
9) cons of collective investment schemes for an individual investor
i) Management expenses
ii) Losing freedom of investment choice
iii) Tax may be greater than individual tax
10) Two principles of investment
a) Selection of investment appropriate to nature, term, and currency of liabilities and provider’s appetite for risk
b) Subject to above, maximize overall return on assets where overall return includes both income and capital
11) Four classifications of liability types and the factors to consider when choosing suitable assets to match each of these types
a) Guaranteed in monetary terms – benefit specified in monetary terms
b) Guaranteed in terms of an index
c) Discretionary – e.g. bonus payment under with-profit contract
d) Investment-linked – benefits directly determined by value of investment underlying the contract
12) Influences of free assets on the assets held
a) Can move away from a matched position
b) Increase returns by taking on additional risk
c) Acts as cushion to becoming insolvent
13) List of regulatory constraints on assets held (Acronym – TECH SCAM)
Types of assets in which a provider can invest
Extent of mismatching allowed
Currency matching requirement
Hold certain assets, e.g. government bonds
Single counterparty maximum exposure
Custodianship of assets
Amount of any one asset that can be used to demonstrate solvency
Mismatching reserve
14) Active vs. passive management – definitions and pros/cons
a) Definition
i) Active - manager has few restrictions, more judgement and flexibility than passive
ii) Passive – holding of assets reflecting certain index or specific benchmark, little freedom of investment choice
b) Active management – Pros/Cons
i) Pros - produce greater returns
ii) Cons - transaction costs, risk that manager’s judgement is wrong
c) Passive management – Pros/Cons
i) Pros – reduced transaction costs relative to active, can spend resources (research, time) elsewhere
ii) Cons – index may perform badly, tracking errors
15) Definitions of backwards and forwards tracking error and active money position
a) Backward looking tracking error – annualized standard deviation of difference between portfolio return and benchmark return based on relative performance
b) Forward looking tracking error – estimate of standard deviation of returns relative to benchmark that portfolio might experience in the future if its current structure were to remain unaltered
c) Active money position – deviation from benchmark portfolio for a specific position
16) Descriptions of the risk budgeting process
a) Process of establishing how much risk should be taken and where it is most efficient to take the risk in order to maximize return
b) It is an investment style where capital allocation is based on an asset’s risk contribution to the portfolio as well as on the asset’s expected return
17) Description of pure matching and its limitations,
a) Pure matching – structuring flow of income and maturity proceeds from assets to coincide precisely with net outgo from liabilities
i) Limitations – rarely possible unless risk-free zero-coupon bonds can be used, dealing costs may be high, suitable assets may not be available
17) Description of liability hedging and its limitations
b) Liability hedging – assets chosen to perform in the same way as liabilities e.g. immunisation, matching by currency, real or nominal nature of liabilities
i) Limitations – sometimes cannot find assets that exactly match liabilities
17) Description of immunisation and its limitations
c) Immunisation – specific example of liability hedging, values of assets and liabilities hedged to small movements in interest rates
i) Limitations – relate only to specific characteristic of liabilities, may not work for large interest rate changes, theory assumes flat yield curve, portfolio must be rearranged constantly, ignores dealing costs, timing of assets proceeds and liability outgo may not be known
a) Deterministic asset-liability modelling
specified values are given for input parameters, output is a single number, can use a number of values for parameters to determine what the outcome is for each scenario
b) Stochastic asset-liability modelling
each input parameter is given its own distribution, the output from model is in a form of a distribution
19) Three non-actuarial techniques for determining an investment strategy
a) Performing a mean-variance optimization without reference to liabilities
b) Basing asset allocations on market capitalizations
c) Shadowing strategies of other comparable institutional investors
20) Definitions of strategic, structural, and active risk
a) Strategic risk – misjudgement regarding asset allocation/asset mix, poor performance of strategic benchmark relative to value of liabilities
b) Structural risk – risk associated with any mismatch between aggregate of portfolio benchmarks and the total fund benchmark
c) Active risk – risk that active management does not generate positive excess returns
d) Overall risk = strategic risk + structural risk + active risk
a) Strategic risk
misjudgement regarding asset allocation/asset mix, poor performance of strategic benchmark relative to value of liabilities
b) Structural risk
risk associated with any mismatch between aggregate of portfolio benchmarks and the total fund benchmark
c) Active risk
risk that active management does not generate positive excess returns
d) Overall risk
strategic risk + structural risk + active risk
