MSc Finance programme

Fund Management module

Week 2:

Setting investment objectives;

asset allocation;
portfolio structuring and review;
evaluating fund manager performance.

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Setting investment objectives
Crucial first issue is often to meet liabilities.
Major distinction is often then between:
• Income
• Capital growth

Then, other considerations come in, including;

• Risk
• Time period for investment
• Liquidity
• Ethics
• Domestic vs. international
• Sharia compliance
• .....

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Asset allocation
'asset allocation' refers to the mix of assets held in a portfolio – both at a
point in time, and how this changes over time.
•'strategic' asset allocation refers to decisions about which 'asset classes'
to invest in, and the 'overall shape' of the portfolio.

Academic research suggests that 'strategic' asset allocation is the

major factor in long-term investment performance.
Sometimes described as 'top-down' approach.
•'tactical' asset allocation refers to the detailed decisions within a
portfolio, and how to invest within an asset class.

For example, whether to invest in 'short' or 'long' bonds; individual

equity selection, etc.
Sometimes described as 'bottom-up' approach.

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 Influences upon asset allocation

• investment objectives – e.g. whether for income, capital growth, capital

preservation, geographic areas, etc.
• asset characteristics – availability, expected returns, risk, liquidity,
market efficiency, etc.
• diversification – need for diversification across different asset classes.
Hence need to examine correlations between returns on different asset
classes.
• tax and legal considerations

• any special constraints – e.g. ethical considerations, nature of

investors.

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 Implications of Modern Portfolio Theory

Assumption is that you are familiar with MPT, so just a quick summary of
the key findings for fund management:

• less-than-perfect correlation of returns on different assets implies that

there are benefits from diversification. SO:

• diversification is beneficial – even if only a little – BECAUSE:

• returns on a diversified portfolio will be less variable than on a

concentrated one. THEREFORE:

• individually risky assets can be combined to provide a portfolio with a

low level of risk overall.

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 Implications of Modern Portfolio Theory (continued)

• When constructing a portfolio the 'trick' is to look for assets with low
'covariance' (i.e. assets whose value does not rise and fall together).

• when you add assets to a portfolio (or take them away), what matters is
how the risk and return of the portfolio changes, and not the
characteristics of the individual asset(s).

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 The Efficient Markets Hypothesis (EMH) and fund
management

Again, assumption is that you are familiar with the EMH, different ‘forms’ of
the EMH, etc. A quick summary of key findings and implications:

• 'efficiency' implies that asset prices are 'fair' or 'correct'.

• 'inefficiency' implies that there is mis-pricing – markets fails to reflect all

relevant available information.
Arbitrage or speculation is then profitable.

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 The Efficient Markets Hypothesis (EMH) and fund
management (continued)
In 'efficient' markets:

• Investment managers, or investors more generally, who are

consistently successful are very hard to find (returns regress to the
mean)
• Equally, it should not be possible to systematically underperform.
• trying to 'time' a market is a waste of effort.
• 'buy and hold' will be a superior strategy to active management
(because transactions costs are minimised).
• benchmarking, and index-tracking, strategies should produce good
results (on average).

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 The Efficient Markets Hypothesis (EMH) and fund
management (continued)

In summary: in 'efficient' markets:

“You cannot do better than ‘the market’ except by chance.”

Trying to do better than ‘the market’ will therefore be a waste of time and
money.

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Asset allocation: one way of looking at asset classes.

overall
portfolio

equities real property bonds cash

'income' 'growth' government corporate

investment
conventional index-linked high yield
grade

emerging
developed
market

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 Returns on asset classes; some long-term data.

Annual real 1900- 1955- 1900- 1900- 1900- 1900- 1900-

returns 1954 UK 2000 2000 2000 2000 2000 2000
(%) UK UK USA Germany Japan World
Average

Equities 3.8 8.1 5.8 6.7 3.6 4.5 5.8

Bonds 0.6 2.1 1.3 1.6 -2.2 -1.6 1.2

Bills 0.3 1.9 1.0 0.9 -0.6 -2.0 n/a

Source: Dimson, E., Marsh, P. & Staunton, M (2002), Triumph of the Optimists; 101
Years of Global Investment Returns, Princeton University Press.
Tables 3-2, 33-1, 26-1, 34-1.

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Fund management 'language' and asset allocation
beta – as in the CAPM; the correlation between the return on a
particular asset and the market return. Hence, a measure of the
sensitivity of the return on an asset to the return of the market
portfolio.
If beta = 1, the asset has the same risk as the market portfolio;
beta less than 1 means the asset has less risk than the market
portfolio, greater than 1 = more risk.

alpha – the unsystematic return on an asset.

alpha is the extra return on an asset over a period of time, relative to
the market.
alpha can be positive – but can also be negative.
If the CAPM holds true, alpha should be zero.

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Fund management 'language' and asset allocation

'active' fund managers – try to achieve a positive alpha in a portfolio –

e.g. by systematically exploiting mis-pricing. Negative alpha is
possible; active managers may not be very good at beating the market.

'passive' fund managers – try to match the market return. That is, they
are not trying to achieve positive alpha.

active managers try to generate excess returns by being 'overweight' in

strongly-performing assets, and 'underweight' in weakly performing
assets relative to the benchmark.

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 Active versus passive asset management
• an active manager believes it is possible to 'beat the market' because
of skills and ability to conduct research to identify good opportunities
and avoid bad ones.
problem; the majority of active managers perform worse than the
market average, so even if we accept active management can be
successful, an investor still has to find the managers who are able to do
this.

• a passive manager does not try to 'beat the market', because of belief
that it cannot be done consistently. By matching the market, the
manager aims to minimise transaction costs and avoid poor 'active'
decisions.
problem; if the market is not 'efficient', the benefits of matching the
market are reduced, but a market needs active managers to eliminate
'anomalies' for it to be efficient.

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 contrasting active and passive fund management
Active managers passive managers
Objectives beat the index (market) match the index (market)
beat peer group
fund management discretionary rules-based
mandate

risk attitude accept diversifiable risk avoid diversifiable risk

investment approach active stock/sector selection track index

buy and sell buy and hold
market timing
discretion as much as mandate allows – may none – stay invested in index (market)
hold cash, go short, gear up etc.

coverage all markets 'efficient' markets where indices exist,

all assets
analytical technique many – but managers' discretion
as to which are used, and
importance attached to them
are representative and can be
replicated – focus on developed equity
markets
quantitative, to ensure portfolio matches
index (market)
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 The 'core – satellite' approach

• increasingly popular approach – seeks to get 'best of both worlds'.

• the arguments for passive management are accepted, at least for

some asset classes (those for which markets are considered efficient).

• the majority of funds are invested in passively managed investments

• a proportion of funds are invested in actively-managed investments

• the justification; the investor uses low-cost passively managed funds,

but is willing to pay for (hoped-for) outperformance of actively-managed
funds.

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 Benchmarks
• represent what the fund manager is expected to achieve.

• are usually stated by reference to a relevant market index (or a

combination of market indices).

The demand for benchmarks drives the demand for indices and stimulates
competition between index providers.

When investors (or their advisers) set benchmarks they may (should?)
also:

• state the extent of divergence from the benchmark permitted;

• reflect the specific requirements of the investor or fund.

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 Benchmarks

An equity index will identify all the companies, and the proportions, which
constitute that index.
FTSE 100 index in January 2015: 12 largest companies by market cap:
HSBC Holdings 6.7%
BP 4.3%
GlaxoSmithKline 3.8%
Vodaphone 3.3%
British American Tobacco 3.3%
AstraZeneca 3.3%
Royal Dutch Shell 3.1%
Lloyds Banking Group 3.1%
SAB Miller 3.0%
Diageo 2.6%
Rio Tinto 2.4%
Barclays 2.3%

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FTSE 100 since inception (from Financial Times 28 Jan 2014)

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Financial Times

• Register using your SHU email at ft.com

• The following article argues for passive
investment (FT Wealth, 23.06.2011):

https://next.ft.com/content/e93e493a-9cbc-
11e0-bf57-00144feabdc0

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Seminars this week, lecture next week:

Seminars this week:

Benchmarks, indices, measuring fund manager performance, investment
styles and themes

Lecture next week:

Retail fund management products

Take a look at the major features of the retail fund management products.
Use the UK as a reference point, but will be looking at products in
other countries also.

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