Investment Management

Question 1

Active and passive management

Answer 1

Active - where the investment manager has few restrictions on investment choice within a broad remit. It is expected to produce greater returns despite extra dealing costs and risks of poor judgement.

Passive - 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 and the index performing poorly.

Question 2

Tactical asset allocation

Answer 2

Involves a short-term departure from the benchmark position in pursuit of higher returns. Before making a tactical switch consider:
• the expected extra returns compared with additional risk
• any constraints on changing the portfolio
• the expenses of making the switch
• any problems of switching a large amount of assets

Question 3

Risk budgeting

Answer 3

A process that establishes how much risk should be taken and where it is most efficient to take the risk (in order to maximize return)
With regard to investment risks, the risk budgeting process has two parts:
• deciding how to allocate the maximum permitted overall risk between active risk and strategic risk
i.e. how much risk individual fund managers are allowed to take in order to out-perform their allocated benchmarks and how far to depart from the theoretically matched benchmark

• allocating the active risk budget across the component portfolios
e.g. how much risk the UK equity managers can take, how much risk the UK bond manager can take, etc.

Question 4

Portfolio construction

Answer 4

Typically constructed to meet two objectives:
1. Ensuring security
2. Achieving high long-term returns

The process of quantifying risk often involves dividing risk into:
1. Strategic risk - the risk that the strategic benchmark does not match the liabilities

2. Active risk - the risk taken by the individual investment managers relative to the given benchmarks
3. Structural risk - where the aggregate of the individual investment manager benchmark does not equal the total benchmark of the fund

Question 5

Monitoring investment performance and strategy

Answer 5

It is necessary to review the continued appropriateness of any investment strategy at regular intervals because:
• the liability structure may have changed significantly
• the funding or free asset position may have changed significantly
• the manager’s performance may be significantly out of line with that of other funds

Question 6

Measuring investment risk

Answer 6

Historic tracking error: the annualized standard deviation of the DIFFERENCE between actual fund performance and benchmark performance - eg. Standard deviation of actual fund performance- benchmark performance

Forward-looking tracking error: modeling the future experience of the fund based on its current holdings and likely future volatility and correlations with other holdings

Strategic risk can be measured using forward and backward-looking approaches, assuming relevant parts of the portfolio were invested in the appropriate benchmark indices, and the effects of the actual strategic allocations compared with the target allocation

Allowances need to be made for diversification benefits when analyzing investment risks

Question 7

Analysis of investment performance against a benchmark

Answer 7

Simplest approach: input all the cash inflows and outflows on a spreadsheet that also holds the daily values of the benchmark

Care needs to be taken for treatment of income. If the index includes income reinvested, then should ignore income as cashflow in the actual portfolio but include in valuing the new end-period value of assets.

Question 8

Money-weighted rate of return

Answer 8

Discount rate at which PV inflow = PV outflow of the portfolio

Problem: places great weight in performance when the fund size is highest. Deposits and withdrawals are often outside the control of fund managers

Question 9

Time-weighted rate of return

Answer 9

The compound growth rate of 1 over the period being measured. No account is taken of flows of money into and out of the portfolio

The same basis on which benchmark indices are calculated

Question 10

Collective investment schemes

Answer 10

Usually priced daily or less frequently. Intra-day movements in certain markets can be material. Need to capture benchmark indices at same time of day