Archive for February, 2008

Identifying Financial Risk Exposures

Financial risk exposures include market risk, credit risk and liquidity risk.

Market risk relates to interest rates, exchange rates, stock prices and commodity prices. How will changes in these factor affect the portfolio, particularly in the context of asset/liability management?

Credit risk is the loss caused when a debtor or the counterparty in an agreement fails to make a payment. It can be managed using credit derivatives, or simply by using traditional credit analysis techniques in order to screen counterparties.

Liquidity risk is an inability to efficiently buy or sell an asset. It is important to realize that a security’s liquidity can change during the investor’s time horizon. Changes in asset liquidity, particularly when liquidity declines, have an important impact on the overall ability of a portfolio to meet client objectives.

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

The Role of the Investment Policy Statement

An investment policy statement serves as a governing document for future investment decisions. It should incorporate the investors objectives for risk and return, as well as specific constraints. The role of an investment policy statement is to ensure that all future investment decisions are consistent with the objectives and constraints.

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

Characteristics of Investments in Commodities and Their Role in a Portfolio

Commodities have very low correlations with traditional assets such as stocks and bonds, and therefore can be strong diversifying agents even though their long-term expected return is lower. In particular, commodities often rise during times of financial distress while other assets are falling and the diversification benefit is needed most.

Over the long term, commodity returns are explained by the business cycle, a convenience yield resulting from the ability to time consumption, and real options that allow the producers of commodities to adjust their production levels in response to prices.

Commodity investments, particularly those in storable commodities such as oil and metals, also offer a hedge against inflation. This is especially true during periods in which inflation rates change unexpectedly.

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

The Role of Real Estate in a Portfolio

Real estate offers significant benefits to a diversified investment portfolio. These include:

  • A low correlation with the returns on investments in stocks and bonds, which improves the overall diversification of a portfolio.
  • Income enhancements from property rental offer a stable revenue stream and reduce return volatility.
  • REITs have a higher Sharpe ratio (risk adjusted return) than stocks or bonds.
  • A low correlation between real estate investments (geographic and sector diversification within real estate).

Although real estate improves diversification relative to a portfolio of stocks and bonds, it has demonstrated less benefit when added to a portfolio that also includes hedge funds or commodities. The diversification benefits may be redundant to those of other alternative asset classes.

Investing in real estate also poses special due-diligence concerns, including the valuation method, financing opportunities, legal issues such as zoning and title checks, and taxes.

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

Components of Total Active Return and Risk

Active return consists of true active return plus misfit active return, where:

  • True active return = the manager’s return – the manager’s normal benchmark
  • Misfit active return = the manager’s normal benchmark – the investor’s benchmark

Active risk consists of true active risk plus misfit risk, where:

  • True active risk = the standard deviation of true active return
  • Misfit risk = the standard deviation of misfit active return

Posted on 25th February 2008
Under: Active Management, Institutional Investing, Investment Returns, Portfolio Management | No Comments »

Return Maximization in Immunized Bond Portfolios

The general purpose of portfolio immunization is risk reduction. In some cases, however, earning an additional return can more than compensate for increased volatility.

For example, an investor may be able to immunize a portfolio to a 6.0% return, or to accept a 6.5% return with a 95% confidence interval of 50 basis points. In such a case, 19 times out of 20 the latter strategy would result in a greater return than the immunized portfolio, and the investor may be willing to accept the risk.

The minimum acceptable return would be determined by the required terminal value, plus a safety margin called the cushion spread. This strategy immunizes the lower bound of the confidence interval limit on realized returns.

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

Active Management in Fixed Income Portfolios

Active management strategies seek to add value by earning a higher return than their benchmark index. In fixed income portfolios there are two primary approaches to active management:

Large Risk Factor Mismatches

This strategy takes deliberate and sometimes sizable mismatches on risk factors other than duration, including credit spreads, yield curve and sector exposure. The goal is to earn more than enough additional return to compensate for the higher transaction costs.

Full Blown Active Management

Full blown active approaches seek only return maximization. They will accept large mismatches on any risk factor, including duration, in order to add value relative to the index.

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

Strategic Asset Allocation Concerns for Individual Investors

Among the most important asset allocation considerations for individual investors is human capital – the present value of expected future earnings. Normally, human capital decreases over time as the investor ages and financial capital increases over time through savings and investment returns. Asset allocations should strive to consider the interaction between financial and human capital.

  • Safer labor income could permit a higher allocation to risky financial assets
  • Higher labor flexibility (for example, part-time work in retirement) would permit a higher allocation to risky financial assets
  • Correlations between human capital and financial markets (such as for a stockbroker, who may lose employment in a poor financial market) should result in lower allocations to the correlated financial assets

Human capital faces two types of risk that are not shared by financial capital:

  • Mortality risk is the loss of income for family members when the investor dies earlier than expected. This risk can be hedged using life insurance.
  • Longevity risk is the potential that the investor will outlive his or her financial assets. This can be at least partially controlled by using annuity products.

Most individual investors are fully taxable, so risk and return should be measured on an after-tax basis.

Posted on 22nd February 2008
Under: Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management | No Comments »

Dynamic and Static Approaches to Asset Allocation

When allocating assets among different asset classes, it is important to consider that the actual returns and liabilities experienced in one period will directly affect the optimal asset allocation decision in subsequent periods.

Dynamic asset allocation approaches explicity consider these linkages, which can help improve asset/liability management.

Static asset allocation approaches do not consider the links between time periods, but are less costly to implement and less complex to model.

Posted on 20th February 2008
Under: Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management | No Comments »

International Economic Linkages

World economies are increasingly linked due to both macroeconomic factors and the effect of linked interest and exchange rates.

Macroeconomic factors include the balance of trade and foreign direct investment. These can cause economic trends in one country to influence the trends of trading and investment partners.

Exchange rate pegs directly link economies, with interest rate differentials between the countries reflecting faith in the peg.

Interest rate differentials can also be affected by capital flows. Higher yielding currencies attract capital, boosting the currency’s relative value.

Posted on 19th February 2008
Under: Economic Analysis | No Comments »