Part 4: Chapter 14, 15, 16 and 17 Relationship between assets classes, Choosing an investment strategy, Asset-Liability Management and Investment management Flashcards
Required return
RR= Risk free real return + expected inflation + risk premium
Expected return
ER = Yield + Yield growth
Why nominal return may not equal GRY
Default risk
Reinvestment risk
Tax
Exchange rate
Dealing costs
Investment risks
Probability of default
Variability of return
Failing to achieve the investors objectives
Failure to prove solvency on a ongoing or discontinuance basis
Under performing compared to competitors
Main factors influencing institutional investment strategy
- Accounting Regulations
- Size of assets(absolute/relative)
- Accrual of future liabilities(Writing more business)
- Diversification
- Currency of current liabilities
- Uncertainty of liabilities
- Tax and cashflow considerations
- Ease of valuation
- Environmental/social/governance issues
- Risk appetite
- Institution’s objectives
- Nature of liabilities
- Voluntary and legal restrictions
- Existing portfolio
- Solvency requirements
- Term of liabilities
- Competition strategies
- Return (Expected)
Main factors influencing individual investment strategies
Practical considerations
Lack of cash
- No direct investment
- High expenses
- Cannot diversify
- Cant exploit short term opportunities
Limited knowledge
Returns from different asset classes
- Feel-good factors (utility, peace of mind)
- Undervalued assets
- Tax considerations (income vs capital gains)
Investment Freedom and constraints
- Liquidity needs
- Uncertainty (provided for in liquid assets + insurance)
- Risk appetite
- Excess assets (Constraint on type of assets to choose)
Nature of assets and liabilities
Expenses
Expertise
Spread of market values (Volatility of market values mainly short term effects)
- Emotional effect
- Term of investment
Investment constraints for individuals
Lack of access to research facilities
Lack of up to date investment information
Lack of expertise to invest directly
Lack of time available
Not always have cash available for
- Short notice investment opportunities
- Achieve economies of scale
- Direct investment and remain well diversified
- Directly invest in large unit sizes
Investment characteristics
SYSTEM T
Security (risk)
Yield (real or nominal, running yield, expected return, compare with other assets)
Spread (diversification, volatility)
Term
Expenses / exchange rate
Marketability
Tax
Principles of investment
Match Liabilities on:
Certainty
Amount
Nature
Term
Currency
While also:
Maximising Return
Taking into account Risk appetite
Types of benefit payments and asset strategies to use to match nature
GIDI
Guaranteed in nominal terms
- Choose approximate matching assets (Fixed interest bonds)
- Larger amount of free assets needed when providing guaranteed benefits
Index linked
- Match with assets following the same index or equities
- real liabilities —> Inflation linked bonds, equity or property
Discretionary (Highest expected return possible)
- Match PRE
- Stay within risk appetite
- Limited matching strategy followed
- Highest return assets classes —> Equity, property
Investment linked:
- e.g. Unit linked
- lower investment risk
- PRE needs to be satisfied
- Can use CIS
Regulatory limitations of investments
- Types of assets that can be invested in
- Extent of mismatching allowed
- Currency you may hold
- Single counterparty maximum exposure
- Custodianship of assets (Not use other companies)
- Amount of any one asset used to demonstrate solvency
- Mismatching Reserve
Objectives:
Control
Limit
Set coherence in the industry
Limitations of Redington’s immunisation theory
Fixed nominal values assumed
Assets of long enough duration may not exist
Timing of asset proceeds/liability outgo unkown
Dealing costs ignored
Rebalancing after every change in interest rate
yield curve assumed to be flat
Profit from mismatching eliminated
Interest rate changes assumed to be small
Steps required to perform a stochastic A-L mathcing modelling exercise
- The Objectives of the strategy need to be defined clearly
- Simulations of assets and liabilities over the full run off period of the liabilities produced
- New business added or not, depending on the objectives
- If NB is included, projected sales can be obtained from business plans and input from marketing and sales departments
- Depending on the size of the book and computing power, it may be necessary to select model point parameters
- Appropriate input assumptions are required such as distribution parameters of assets, correlation between assets and liabilities
- Projections should be based on best estimate assumptions
- An initial strategy is tested by projecting the Assets and Liabilities under several thousand simulations to derive a probability distribution and to determine the suitability of the strategy
Aspects of an Asset Liability model
OPHACC
Objectives of investment formulated
Performance target set
Horizon of performance set
Assumptions of model set
Confidence levels of performance determined
Continuously run and assess the model
Three types of asset-liability matching
Pure Matching
Approximate Matching
Immunisation
Active vs Passive investment
Active Investment:
Investment manager has little restrictions on the investment choice with a broad benchmark of asset classes. The manager is allowed to buy and sell whenever he thinks there is an opportunity. Mispricings can identified and leveraged
Passive investment:
Involves buying and holding asset classes which closely reflecting those underlying an index or specified benchmark. The investment manager has little freedom of choice.
Considerations before implementing Tactical asset allocation
Constraints on the changes that can be made to the portfolio
Expected extra return relative to any additional risk
Expenses of making the switch
Level of assets available (Proportion of assets moved)
Tax implications (realisation of any capital gains will result in tax) and timing of the deviation
What is Risk budgeting? Why do it?
Process of establishing how much risk should be taken and where it is most efficient to take the risk.
Two parts:
- Deciding how to allocated the maximum permitted overall risk between active and strategic risk
- Allocating the active risk budget across the component portfolios
The goal of risk budgeting is to establish a risk culture within the company
Risks Investment managers face
SAS
Strategic risk- reflects the error the company makes in choosing its broad assets class to suit its liabilities and the chosen assets may still perform poorly, even if chosen correctly Structural risk - reflects the error company can make while dividing up its portfolio (could be intentional or unintentional) Active risk- reflects the error the individual managers can make while they chase higher returns
Money weighted rate of return
The rate where the present value of cash inflows = present value of cash outflows
Generated cashflows ignored, only new money considered
Puts higher weighting when the fund was large
Unfair towards investment managers performance since deposits/withdrawals is out of his control
Time weighted rate of return
The compounded growth rate of 1 over the period being measured
Does not take into account inflows or outlfows of money into the fund. Does not take into account managers with skill at handling larger portfolios
Merits of Active investment
Expected returns are higher
Limited Restrictions on investment
Judgment error risk exists
Efficient market hypothesis - inability to outperform
Dealing//trading costs
Merits of Passive investment
Expenses are less
Index tracking is possible
Smaller volatility (but also expected return)
Poor index performance possible
Investment freedom is restricted
Tracking errors possible
