CHP 28 Flashcards
1.1. Active investment management
The investment manager has only few restrictions – possibly only a broad benchmark of asset classes. This enables them to make judgments on future performance of individual investments, both long- and short-term.
Active management is generally expected to make higher returns than passive due to the freedom of choice.
This will however likely be offset by the extra costs involved in more regular transactions – particularly when trying to make short-term gain. There is also the risk that the judgment is wrong and it results in lower return.
1.2. Passive investment management
Hold assets that closely reflect those underlying a certain index or specific benchmark. The manager has little freedom to choose.
Passive investment is not risk free as the index could go down and there is tracking error.
Historic tracking error
Until recently, most attention was given to measuring and managing active risk.
The most usual backwards risk measure adopted is the retrospective or backwards-looking tracking error – the annualized standard deviation of the difference between portfolio return and benchmark return, based on observed relative performance.
Forward-looking tracking error
An estimate of the standard deviation of returns (relative to the benchmark) that the portfolio might experience in the future if its current structure were to remain unchanged. This measure is derived by quantitative modeling techniques and depends on assumptions including:
• The likely future volatility of individual stocks or markets relative to the benchmark
• Correlations between different stocks and / or markets
2.2. Active money
Is the deviation from the benchmark portfolio for a specific position. If all the active money positions are zero, the portfolio is run in a perfectly passively, index-like fashion.
The active money position of a stock does not provide a complete picture of the risk of such a position relative to the benchmark. This is because some stocks are more likely to perform different from the benchmark than others.
- Risk budgeting
This is a process of establishing how much risk should be taken and where is the most efficient to take it.
With regard to investment risks, the risk budgeting process has 2 parts:
- Deciding how to allocate the maximum permitted overall risk between total fund active and strategic risk
- Allocating the total fund active risk budget across the component portfolios
- Risk budgeting
The key focus when setting strategic asset allocation is the risk tolerance of stakeholders in the fund. This is the systemic risk they are willing to take to enhance long-term returns.
The key question on active risk is that is it believed that active management generates positive excess returns.
A risk budgeting strategy may free managers to look for alternative investments that might increase the expected return on the portfolio. This is because the total risk of the portfolio must stay below a certain level, thus increased attention is given to low correlation investment.
Allocations to such investments can reduce the overall risk of the portfolio via diversification.
4.1. Pure matching
This is structuring the flow of income from assets to coincide exactly with the net outgo from liabilities under all circumstances.
This requires the sensitivity of the timing and amount of both assets and liabilities to be known with certainty and to be identical with respect to all factors.
4.2. Matching in practice
Given infinite resources, it will always be possible to meet the outgoings by buying excessive amounts of securities.
In practice, matching is thus the portfolio that is the cheapest and still provides the required certainty of meeting the liabilities.
Unless risk-free zero coupon bonds can be used, it is rarely possible to do pure matching. It may be possible to achieve a level close to this for some life insurance products e.g. guaranteed income bonds.
Also, the relative price of the bonds chosen for the matching may be such as to deter all but the most dogmatic institutions.
For some funds, the term of liabilities and available assets makes it impossible for pure matching.
- Actuarial techniques for determining investment strategy – asset-liability models
An investor’s objectives will normally be states in terms of both assets and liabilities.
Asset-Liability modeling projects the proceeds of assets and the payment of liabilities at the same time.
This encourages investors to formulate explicit objectives.
These should include:
• Quantifiable and measurable performance targets
• Defined performance horizons and
• Quantified confidence levels
• For a financial institution the objectives might be specified in terms of the results of a future valuation.
In practice, there is likely to be feedback between model output and setting objectives.
The outcome of an investment strategy is examined with the model and compared to investment objectives.
The investment strategy is then adjusted in light of the results obtained, this process is iterative.
The modeling can be deterministic or stochastic.
The success of the strategy is then measured by regular valuations. The results of the valuations will then be compared to that projected by the model. Adjustments will be made to the strategy to control the level of risk accepted by the strategy.
Investors should formulate explicit objectives.
These should include:
• Quantifiable and measurable performance targets
• Defined performance horizons and
• Quantified confidence levels
• For a financial institution the objectives might be specified in terms of the results of a future valuation.
In practice, there is likely to be feedback between model output and setting objectives.
- Non-actuarial techniques for determining investment strategy
Other techniques for establishing a benchmark strategy include:
• Performing a mean-variance optimization without reference to the liabilities.
• Basing asset allocations on market caps.
• Shadowing the strategies of other comparable institutional investors
- Liability hedging
Liability hedging is where assets are chosen in such a way so that they perform in the same way as the liabilities.
7.2. Approximate liability hedging
e.g. immunization
Other familiar forms of hedging include currency matching and consideration of the real or nominal nature of liabilities when selecting asset classes.
These examples only relate to specific characteristics of the liabilities, where liability hedging aims to select assets that perform exactly like the liabilities.
7.3. Full liability hedging
E.g. unit-linked, the value of the assets implies the value of the liability. Problem comes when the assets held are not the same as the value of the liability.
If units are allocated and realized be reference to some external fund, then it is likely that the assets held by the fund will not match the liability at any point. Alternatively the information may only become available after some delay, by which time the external fund might have changed.
e.g. if the value of liabilities is linked to some external index – these could be hedged by OTC derivatives to avoid uncertainty of rolling-over short-term exchange traded derivatives.
