Portfolio management process and agency problems (Week 1) Flashcards
What is portfolio management
managing investment funds towards client’s objectives:
return, risk, liquidity, steady income stream, dividend v capital gains, tax minimisation
what objectives may a retired couple have?
leave enough money for their living
set up family trust
leave money for grand children
Superannuation funds
Corporate super funds
Corporate super funds by corporations. They have own team to manage for their employees
agency problem between investment bank and investors example
investment bank hired as asset consultant by institutional investor
investment bank evaluating several infrastructure projects e.g. second sydney airport, almond farming. recommend 1 alternative asset to institutional investor. Project calls them because they are consultants/advisor for the project. Gets finance for the project. and asks them to do them a favour and recommend their product to institutional investors. In return, they will receive benefit.
asset consultant may not recommend product that will be best interest of their client.
agency problem between investors and aggregators
investors delegates some of management decisions to board members of UNIsuper. are they competent or like to look after investor’s interest
board meets few times a year. how can they monitor investment managers of unisuper?
agency problem between investors and aggregators
investors delegates some of management decisions to board members of UNIsuper. are they competent or like to look after investor’s interest
board meets few times a year monitoring?
agency problem between investors and financial planners
buy Australian equity fund from colonial first instead of other. push you to buy products that generate the highest commission
agency problem between investors and financial planners
buy Australian equity fund from colonial first instead of other. push you to buy products that generate the highest commission
what happens when you delegate asset allocation decision to someone else?
agency problem
financial planner
over 70% of changes recommended by financial planners are not necessary. just want to generate sales and revenue.
still a lot of work in financial planning industry.
investment manager
they have their own access to particular asset
aware of new investment opportunities
better access to assets
where does the actual asset allocation or portfolio management happen
investment manager
where does the actual asset allocation or portfolio management happen
investment manager
where does the actual asset allocation or portfolio management happen
investment manager
Superannuation funds
SMSF
Need 200k to establish
manage own superannuation in account
compliance and reporting regulations
2012 regulation changed so they can borrow funds to buy real estate
Superannuation funds
Public-Sector
Defined contributoin.We pay you super guarantee but not going to guarantee certain amount of benefit.
What you receive when you retire depends on amount invested in account
Superannuation funds
Public-Sector
Defined contributoin.We pay you super guarantee but not going to guarantee certain amount of benefit.
What you receive when you retire depends on amount invested in account
Superannuation funds
Industry super fund
Low fees.
not for profit
value for money fund management
This year, industry super fund has been scrutinised about effectiveness for helping members. No sufficient supervision or monitoring, lazy portfolio managers charging flat fee and not doing their job
Endowment and Foundations
Harvard endowment
during GFC, harvard endowment was hurt badly because of illiquidity of alternative assets and could not offload onto alternative assets
Insurance companies?
have reserves to pay compensation
collect insurance premium from insurance policy and make investment and keeps investment returns
Types of agency issues
•Tiered approach to portfolio construction
−Buckets at various tiers of the process
−Portfolio => asset classes => portfolio managers => assets
several portfolio managers for equity asset class.
Some will be specialised in australian, european etc
portfolio construcuted by various tiers
Types of agency issues
- Delegated management => agency problems
- What investors want versus what managers want
- Tiered approach to portfolio construction
−Buckets at various tiers of the process
−Portfolio => asset classes => portfolio managers => assets
An asset management decision process
•review
–Performance measurement & evaluation
–Monitor & adjust
An asset management decision process
•implement
how am i going to invest 60% of funds into high growth? australian equity? emerging equity?
–Asset class strategy & portfolio structure
–Manager or asset selection
–Execution
An asset management decision process
•Plan
- governance
- objectives and constraints
- asset allocation
An asset management decision process
•Plan
–objectives and constraints
decide objectives and constraints
set up separate account to manage 5m for retired couple. are they trying to generate income for retirement living?
Given objectives and constraints, 60% in high growth assets and 40% in fixed income
An asset management decision process
•Plan
–Governance
set up a new fund, need to establish governance system to decide who is responsible for what. how performance is evaluated and their specific responsibilities
An asset management decision process
•Plan
–Governance
–Objectives & constraints
–Asset allocation
Describe growth in alternative assets
alternative assets such as private equity, hedge funds, properties and infrastructures etc.
30 years ago 1% of average portfolio
Now 20% of average portfolio
Funds management industry in relation to GDP
Funds management industry in relation is growing faster than GDP.
Growth market of funds management industry si 5-6% in most of developed market
Trend in pension funds?
Australia pension funds have highest percentage of defined contribution funds. Members have full responsibility of funding their own retirement instead of receiving a certain amount of retirement benefit or pension
Japan, members are entited to certain amount. risky promise made by gov or corporation
is there a shift from passive management strategies to active?
No, shift from active management strategies to passive partially because of high fees
e.g. Vanguard, ETF (active management strategies).
Asset Allocation Process
- Understand Investor’s objectives and circumtances
- Transform investor’s objectives into quantifiable and unquantifiable measures
- collect financial and economic forecast data and conduct qualitative and quantitative analysis e.g. portfolio simulations
- Assign asset weights so that investor’s objectives can be achieved
- Decide how portfolio manager’s performance can be evaluated
Feature of SMSF funds
Last 10-20 years, they have been growing faster than corporate and retail funds in australia
identify 3 major trends observed over the last 5-10 years
Asset class trends
Reduction in equities – main counterpart to increase in alternative mentioned above.
– ‘De-risking’ by some investors, through increasing fixed income. Particularly notable for DB funds, who are responding to increasing deficits by aiming to hedge liabilities.
– Reduced home bias in equities, i.e. global diversification
– Reduced home bias in Australian bonds, mainly due to the fact that Australian bond market is very small relative to the world market
identify 3 major trends observed over the last 5-10 years
Growth segments
Other ‘alternative’ assets: private equity and hedge funds (until 2007, then drift);
commodities in more recent years; infrastructure currently growing in popularity
– ETFs (exchange-traded funds)
– SWFs (sovereign wealth funds)
– Private wealth management
identify 3 major trends observed over the last 5-10 years
GDP
High growth rates (faster than GDP) - although some stalling post-2007 / GFC
Major Trend
Concentration
concentration of fund managers at top (Blackrock, Vanguard, State Street); but growth of boutique managers is also occurring
Major Trend
increase in
Increase in passive investing, at expense of active funds
• Increased regulation
Major Trend
increase in
Increase in passive investing, at expense of active funds
• Increased regulation
Major Trend
DB and DC Funds
Movement towards DC pension funds, away from DB funds. Australian pension is dominated by DC, highest in the developed countries
Increases in DB fund deficits (GFC, lower interest rates, aging populations)
Trend in Super
In Australian superannuation, ‘industry funds’ and self-managed super funds (SMSFs) winning share; while ‘retail funds’ (and corporate) struggling
Two major drivers of volume and composition of funds under management (FUM)
Other influences of note:
– asset demand can be driven by: investor preferences; economic development; demographics, e.g. saving for retirement
– asset supply / availability – disintermediation – rebalancing of portfolios, i.e. shifting, or restoring, asset weightings
– regulation (e.g. restrictions on leverage; what assets SMSFs can include in the fund)
Two major drivers of volume and composition of funds under management (FUM)
Asset returns, revaluation of assets within existing portfolios
Cash flows, i.e. investors making new investments, or redeeming
Composition of FUM and finance theory (i.e. modern portfolio theory, CAPM)
Investor portfolios unlike the CAPM market portfolio (does not span all assets; home bias)
- Markets are segregated with many frictions. More like “buckets” than integrated pool.
- Multiple investors, structures and objectives. ‘Separation’ of MPT does not seem to hold.
- ‘Delegated management’ to managers, with weak links to utility of consumption or wealth
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
- Commissions on product sales
Impliction
Investor directed towards managers paying highest front-end loads and trailers, not necessarily best managers for investor. (Note: Commissions being purged in Australia.)
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
7.
Commissions on product sales
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
- Brokerage and other costs paid by investor, but controlled by the manager
implication
Open for abuse by manager – brokers can offer benefits to manager (e.g. entertainment) to get them to trade
• Example: ‘soft dollar’ transactions (these involve brokers paying for certain services in return for a promise to pay brokerage - mostly frowned upon)
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
6.
Brokerage and other costs paid by investor, but controlled by the manager
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
- Incentives to increase risk when ‘optionality’ exists for manager (e.g. bonus paid on yearly returns; performance fees; high leverage)
implication
- Options are more valuable under high volatility => incentive to take risk (‘heads I win, tails you lose’)
- Investor subjected to more risk than appreciated
- More of an issue in hedge funds, private equity, etc
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
5.
Incentives to increase risk when ‘optionality’ exists for manager (e.g. bonus paid on yearly returns; performance fees; high leverage)
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
- Ongoing evaluation of manager performance
implication
This can lead to ‘short-termism’, i.e. managers trying to maximize short-term returns, rather than longer-term performance
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
4.
Ongoing evaluation of manager performance
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
- Peer ranking considerations
- Reluctance to try something new, even if in investor’s best interest, as raises risk of underperforming peers.
- Manager “career risk” (i.e. risk of losing one’s job due if one of the worst performers) leads to benchmark hugging and other forms of herding
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
3.
Peer ranking considerations
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
- Benchmark
Benchmark need not align with investor objectives
Managers may game benchmark by either seeking risk premiums or off-benchmark exposures
Varying risk to manage relative performance (i.e. hug benchmark if ahead, go for broke if behind). Investor gets not enough risk, or too much.
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
2.
Managing to benchmarks
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
fund management companies and fund managers have incentive to increase fees and FUM (profits and bonus motives) while investors
implication
- Managers want to keep fees as high as possible, but this directly reduces investor returns. (Good managers will sometimes be able to charge a higher fee.)
- If FUM increase beyond reasonable capacity for strategy, returns are eroded.
- Result is that much of the value-add from investment skill may be secured by manager themselves, rather than accruing to investors.
A number of agency problems arise from the delegation of the investment process to professional managers. Identify three such problems, and be able to discuss their nature and implications for investors.
fund management companies and fund managers have incentive to increase fees and FUM (profits and bonus motives) while investors
implication
fund management companies and fund managers have incentive to increase fees and FUM (profits and bonus motives)
while investors want to maximize portfolio return
The main agency problems in fund management do not relate to information asymmetry, but rather relate to
lack of alignment (incentives, objectives).
Performance Evaluation.
Performance evaluation provides a
regular assessment of the fund’s performance relative to your investment objectives. Properly conducted, performance evaluation reinforces the hierarchy of accountability, responsibility, and authority defined in the fund’s governance structure. Performance evaluation serves as a feedback-and-control mechanism by identifying the investment program’s strengths and weaknesses
Goal of Asset allocation
to manage variability, provide for cash flow needs and generate asset growth
i.e. risk and return, either absolute or relative to a target or benchmark
How is the client diversified
By holding investments in reasonably uncorrelated assets
many portfolio managers do not make asset allocation decisions. Instead,
they are hired to run a pool of money in a single asset class, or style within an asset class.
Payment by DB Funds is determined by
a pre-specified wage-based formula
Portfolio manager’s goal in DB Funds
to set both asset allocation and funding policities to meet its schedule of forecast future cash flows at the lowest possible cost and lowest risk of falling short of the required outflows
DC Plan is a hybrid program
Role of Portfolio manager
portfolio managers are hired by the company to provide diversified multi-asset options, individual asset class management and customised asset allocation advice
DC Plan is a hybrid program
employee determines how to save and how to invest
company supports this effort with contribution matching and advisory support services
