Archive for January, 2008

Forming an Investment Risk Objective

Since risk and return are related, risk objectives largely influence the return investors can expect to earn.

The first part of a risk objective is to determine how risk should be measured. Often this is done in terms of volatility – the variance or standard deviation of various assets or the overall portfolio. However, it can also be expressed in terms of tracking error relative to a benchmark or in terms of the risk of loss (downside risk or Value at Risk).

The investors willingness to accept risk must be considered, along with the ability to accept risk. Ability to accept risk is influenced by how much volatility would inconvenience the investor or make it difficult to achieve desired wealth targets. Liabilities and the investor’s financial strength outside the portfolio (income) also constrain risk taking. The willingness and ability to accept risk together form the investor’s risk tolerance or aversion.

Risk tolerance must be specified. Saying the investor has low risk tolerance is not as useful as outlining a plan that “loss in any year should not exceed 10%.”

Once the risk tolerance is established, the risk should be budgeted among the various asset choices available in order to maximize the potential return within the investor’s risk tolerance.

Posted on 31st January 2008
Under: Active Management, Asset Allocation, FInancial Planning, Portfolio Management | 1 Comment »

Portfolio Selection, Composition and Implementation in Portfolio Management

Portfolio selection and composition decisions are made by the manager, usually incorporating input from analysts. The manager may also use quantitative portfolio optimization tools to balance risks and return opportunities.

Portfolio implementation decisions are made on the trading desk. They must incorporate both explicit and implicit transaction costs. Explicit costs include commissions, fees and taxes that result from a trade. Implicit costs include the bid-ask spread, potential market impacts from large trades and opportunity costs that arise when orders are filled slowly or cannot be filled at all.

Posted on 30th January 2008
Under: FInancial Planning, Portfolio Management | No Comments »

Enterprise Risk Management

Enterprise Risk Management is a term used to describe a centralized risk governance process that takes place at the level of senior management. It takes a firm-wide perspective, considering individual risk factors both in isolation and in terms of their interplay with other risk exposures.

An effective risk management system seeks to control exposure to:

  • stock market fluctuations, interest rates, exchange rates and commodity prices
  • credit and default risk, asset/liability management, operational systems, fraud and other factors

The steps to effective Enterprise Risk Management are to:

  1. Identify each risk factor to which the company is exposed
  2. Quantify the size of each exposure in money terms
  3. Map the inputs into a risk estimation calculation
  4. Identify the overall risk exposures and the contribution to overall risk derived from each factor
  5. Set up a process for periodic reports to management, who will determine capital allocations, risk limits and risk management policies
  6. Monitor compliance with the policies and risk limits

Posted on 29th January 2008
Under: Governance, Portfolio Management, Risk Management | No Comments »

Investment Constraints

An investment plan must consider both investment objectives and investment constraints. Major constraints include liquidity, time horizon, tax concerns, legal and regulatory concerns and unique circumstances.

Liquidity refers to the need for cash in excess of any savings or new contributions available at a specific point in the future.  Liquidity needs may be planned (child’s college funding in 10 years) or unplanned (a medical emergency) but both require ready ability to convert investments into cash. Some assets, such as real estate, may take considerable time to sell. Others, such as certificates of deposit, may impose early withdrawal penalties.

Time horizon typically refers to the time at which an investment objective must be met. Some objectives such as saving for a house may have a short time horizon, while retirement or endowment planning can have long horizons. Investors must often plan for several time horizons at once. The time horizon influences the ability to accept risk and could modify asset allocation strategy. Investors with little tolerance for temporary return fluctuations may need a different plan than would be suggested by time horizon alone, and multiple time horizons can further constrain allocation decisions.

Tax concerns include differences between the tax rates for different types of investment return (interest versus capital gains or dividends), estate taxes, differences between current income and retirement income tax rates, and the potential for tax legislation to change.

Legal and regulatory factors may include limits on the allocation to specific assets, the ability to access certain funds and even prohibitions on certain investments.

Unique circumstances may include social concerns and specific family needs.

Posted on 29th January 2008
Under: FInancial Planning, Portfolio Management | No Comments »

Components of Total Return for Investments in Commodity Futures

The total return for a commodity futures contract is made up of three components.

  1. Spot return represents the change in spot price of the underlying asset. Since commodities tend to have positive exposure to event risk, it can make up a significant portion of the total return.
  2. Collateral yield or collateral return arises because futures contracts do not require the entire cash position to be paid up front (only margin is due at the outset of the contract.) Collateral yield is the return earned by investing the remaining cash during the term of the contract.
  3. Roll yield or roll return is generated as contracts roll forward in time due to the necessary convergence of spot prices and futures prices. A downward-sloping term structure (which is known as backwardation) results in a positive roll yield, and an upward-sloping term structure (known as contango) results in a negative roll yield.

Posted on 28th January 2008
Under: Active Management, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Portfolio Management | No Comments »

Characteristics of Investments in Real Estate

Investments in real estate have a number of characteristics that distinguish them from other asset classes.

As an asset with intrinsic value, real estate poses advantages over some alternative investments such as commodity trading or hedge funds. In addition, rental income provides a stable revenue stream that improves overall stability of returns.

Against these benefits are a number of specific risks:

  • Illiquidity – it can often take months or more to sell a property
  • High transaction costs – significantly higher legal and brokerage fees than apply to other asset classes
  • Heterogeneity – each property is different, requiring specialized analysis
  • Immobility – location, location, location
  • Low information transparency (the seller has much better information than the buyer)

Real estate values are driven by population growth and interest rates. There may be some inflation hedge inherent to real estate, but empirical studies have produced mixed results on this front.

Posted on 27th January 2008
Under: Alternative Assets, Investing in Real Estate, Portfolio Management | No Comments »

Suitability of Alternative Investments for Private Wealth Clients

There are specific concerns related to alternative investment strategies with respect to private wealth clients. These include:

  • Investor taxability
  • Suitability of funds that require long lock-up periods for investors with liquidity needs or multiple investment horizons
  • Communicating complex strategies to a non-professional client
  • Greater likelihood of decision risk (changing strategies at the point of maximum loss)
  • Clients whose wealth stems from concentrated positions in closely held companies may not be suited to other illiquid investments

Posted on 26th January 2008
Under: Alternative Assets, Portfolio Management | No Comments »

A Completeness Fund for Equity Management

When several managers are selected within an asset class, each may bring specific risk exposures relative to the overall benchmark, but the group of managers may have aggregate characteristics that do not match the benchmark. In such cases, a completeness fund can be used to adjust the overall risk exposures to align with those of the benchmark.

The completeness fund can be managed passively or semi-actively, but must periodically be re-estimated to reflect the changes in actively managed portfolios.

The purpose of a completeness fund is to eliminate misfit risk. However, it may be desirable to retain some misfit risk that results from manager skill in going outside the benchmark.

Posted on 25th January 2008
Under: Active Management, Asset Allocation, Institutional Investing, Passive Management, Portfolio Management | No Comments »

Single versus Multiple Liability Immunization

Portfolio immunization to a single investment horizon is appropriate only when there is one liability that must be met. More frequently, a stream of liabilities or required cash flows must be met, requiring a multiple liability immunization.

Immunizing a stream of liabilities requires funds to pay all liabilities even if there is a parallel shift in interest rates. Duration alone is not sufficient for immunization in this case. The components of total return must be separately available to immunize each liability.

In order to immunize multiple liability streams, the following conditions must be in place:

  • Composite duration of assets matches composite duration of liabilities
  • The distribution of asset durations must be wider than the distribution of liability durations

Posted on 24th January 2008
Under: Asset Allocation, FInancial Planning, Fixed income investments, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Enhanced Indexing Strategies for Fixed Income Portfolios

Enhanced indexing strategies typically seek to minimize tracking error relative to a benchmark index while generating sufficient excess return to cover fund expenses. There are a number of approaches to enhanced indexing with regard to fixed-income (bond) portfolios.

Matching Primary Risk Factors

This strategy uses a sampling approach, with the goal of matching primary index risk factors (such as duration, level of interest rates, yield curve and credit spreads). Compared to pure indexing in a bond portfolio, the sampling method reduces construction and maintenance costs, which generally more than offsets the additional tracking error.

The portfolio should have a similar reaction as the benchmark when exposed to macro factors, and the manager can attempt to add value by finding undervalued bonds.

Small Risk Factor Mismatches

This strategy typically attempts to match only the portfolio duration relative to that of the benchmark index. Managers can attempt to add value by tilting the portfolio in favor of any other risk factor. The mismatches, however, will typically be small in order to minimize tracking risk. The primary goal is to earn sufficient excess return to offset the administrative costs.

Posted on 23rd January 2008
Under: Active Management, Fixed income investments, Investing in bonds, Passive Management, Portfolio Management | No Comments »