Investments Topic 9 - Investment Planning Principles Flashcards
What is a Direct investment
investment bought and held by the investor themselves, with no investment vehicle or wrapper
Benefits and drawbacks of direct investment
Benefits:
- Investments can be tailored exactly to their wants/needs
- Overall costs on a larger portfolio can be very cheap
- Investor knows exactly what the expenses are for each investment
Drawbacks:
- Unlikely to allow for diversified investments unless the investor has a lot of cash
- Overall costs on smaller portfolios generally higher
- Portfolio can be more volatile (due to the lack of diversification)
- If the investor is not a professional, they can make wrong decisions, or hire a professional but this is expensive
- CGT can be paid on gains when switching investments whereas fund managers are exempt
What is Stochastic modelling
allows the adviser to generate thousands of different outcomes of a portfolio for different scenarios. Instead of using only 3, it makes thousands which cover all types of scenarios and give more accurate projections.
For stochastic modelling, Numerous models are available, but they all consist of 3 main components:
All types of variables
- Trend variables – describe and predict the expected turns on various asset classes
- Range variables – show how far above and below trend the returns on the asset class may be
- Relationship variables – reflect the connection between certain events e.g. sharp stock market fall on bond prices
Investment managers can act on an advisory or discretionary basis, what are these
Advisory – based on written client agreement, whereby the adviser must follow the principle of “know your client” and give the client options and they can accept/reject.
Discretionary – based on a written discretionary management agreement. Confirms AtoR and objectives, and adviser can make decisions on their behalf but within parameters of the agreement.
Asset allocation can be achieved by optimisation, what is this
uses the fundamentals of the efficient frontier to allocate assets on a risk and reward basis. Finds the highest level of return possible that stays in line with the clients AtoR.
Backtesting is when
a manager can apply new investment rules to past data to see if it would have been right. This allows the manager to compare the results of the ‘shadow’ portfolio with what really happened.
Asset allocation can be achieved by benchmarking, which is when
manager uses ‘model’ portfolios to establish the asset mix for the client’s portfolio in line with their needs and AtoR. Examples are stock and bond index, Libor etc.
Strategic asset allocation – also known as ‘base policy mix’
When portfolio is first put together, manager establishes a base mix of assets that should produce required returns. This may change down the line due to market movement, and should be reviewed regularly
Tactical asset allocation
also known as ‘active management’. Describes short-term tactical investments that are made outside of the base policy mix. Takes advantage of market situations.
2 broad styles of investment portfolio management
Passive – also referred to as tracking. Tries to match the market/sector rather than beat it.
Active – aim to produce returns above the market
Passive investment management
Indexation (tracking) comes in 4 main ways:
- Full replication – manager buys all shares in the index at the exact same weighting. Neither practical nor cost effective for larger indices.
- Stratified sampling – manager buys a sample of shares from the index, usually separated by categories. Will not provide complete replication.
- Optimisation – manager produces analytical model of market using computers using past performance. Changes to market can outdate this quickly
- Synthetic indexing – rather than holding shares, the manager buys index futures for example as well as low-risk assets i.e. bonds to replicate the performance of the index
Active investment management relies of the manager’s skills to select assets to beat the market. Active funds can be managed in 2 ways:
- Bottom up – true stock picking, selecting shares without reference to their class or sector. The focus is on factors affecting individual firm rather than the whole market.
- Top down – uses macro-economic and general market factors to construct a portfolio.
Top down management uses a 3-stage process
- Establish the portfolio asset allocation and weighting
- Deciding which sector(s) in that class to invest in and the weighting for each
- Individual stock selection through fundamental and technical analysis
Fundamental analysis
detailed analysis of the company and the industry it works in to see if shares are under/overvalued. Analysis of multiple performance measures like earnings forecast, price/earnings ratio, net asset values, cash flows etc.
