Investment Management

Investment Management (FIN206)
Assignment
Total marks: 100
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Instructions to students
•This assignment covers Topics 1 to 5 and accounts for 40% of your final grade.
•There are four (4) questions in this assignment. You should answer all questions.
•The overall word limit for the assignment is 5000 words.

Marks will only be awarded for answers up to the word limit (plus 10%) for each question. Any material written after this will not be counted towards your mark for that question. Headings, quotes and references within the body of the answer are included in the word count. Numerical tables, calculations, and reference lists are not included. For more information on word counts and their rationale, go to Assessment Assignment General assessment information.
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Learning outcomes (LO) mapping Marks
1.Analyse the processes involved in managing an investment portfolio. 20
2.Explain the theoretical concepts underpinning investment management. 20
3.Apply the process of asset allocation and portfolio construction. 50
4.Assess manager selection and portfolio management styles. 10
Total marks =SUM(ABOVE) 100
Criteria-based Marking Guide
The Criteria-based Marking Guide provided at the end of each question is designed to assist students to understand what is expected of them in each question and to let them know how their performance will be judged. It provides advice about the criteria used in the marking of the question and what discriminates between an excellent, satisfactory and unsatisfactory answer.
Background information: ABC Superannuation Fund
ABC Superannuation Fund (ABC) is a scheme that was originally only available to state public servants. It has two parts:
•A defined benefit (DB) scheme
•A defined contribution (DC) scheme.
The ABC DB scheme was closed to new members a number of years ago and is currently in ‘run-off’ mode. The scheme was only ever available to public servants.
In a DB scheme, the fund essentially bears investment risk rather than investors. Investors receive a return at retirement in the form of a pension or a lump sum, based solely on salary and years served in the public service. As the final payment (or lump sum) is effectively guaranteed by the government, members are not provided with information regarding performance. Actuaries have calculated that ABC’s DB scheme is marginally underfunded. At current rates of withdrawal, approximately 3% of the fund’s capital is withdrawn each year and the fund will need to meet liabilities for the next 45–50 years. The average age of investors in the fund is 55, with the youngest 2% of members being age 40.
There are only a few DB schemes left in Australia and each scheme has a different member demographic base.
The DC scheme is popular with both current public servants and those past public servants who now work in the private sector. There are eight options available to members including a number of asset class specific options, a number of diversified options and a socially responsible investing (SRI) option. Almost 80% of DC members are invested in the ‘Balanced Fund’, which also serves as the MySuper option. The average age of members in the Balanced Fund is 50, which is around 20 years above the average member age for other similar funds (peers). The average balance is $80,000, well above the average balance for peers, and the average salary of those members is $90,000 p.a., which is also well above the average salary of members in other Balanced Funds.
Most of the DC scheme’s options, including the Balanced Fund option, have provided fairly competitive returns over the past five years. Nonetheless, in the aftermath of the global financial crisis (GFC), the trustees of the fund would like to undertake a full analysis of the DB scheme and the Balanced Fund option in the DC scheme to ensure that the funds are likely to meet members’ expectations in the future. They are aware that, for example, the members invested in the Balanced Fund do not represent the average cohort in a Balanced Fund, thus their needs may be different. They believe that the funds have been too focused on achieving returns competitive to peers rather than providing long-term real returns or considering the true needs of members. As the other options in the DC scheme are small, they will be considered as a separate project after this one is completed.
Scenario
You are a consultant who has been asked by the fund’s trustee board to work with ABC’s investment team to review a number of facets of both the DB scheme and the balanced fund option in the DC scheme.
In your initial dealings with ABC, you have gathered copies of the incomplete investment policy statements (IPSs) (see Appendices 1 and 2), which provide the basis for the way the investment team manages these funds for both the balanced fund option in the DC scheme and the DB fund.
Note to students: Clearly mark all sections and sub-sections of your answers.
Question SEQ Question * ARABIC 1(12 marks | Word limit: 600 words)
LO1: Analyse the processes involved in managing an investment portfolio.
(a)Analyse the objectives of the defined benefit fund in terms of the return requirements. How do you think they could be improved?(2 marks)
(b)Analyse the objectives of the defined benefit fund in terms of risk management. How do you think they could be improved? (2 marks)
(c)Propose two (2) new objectives for the defined benefit fund based on both return and risk requirements.(2 marks)
(d)Analyse the objectives of the balanced fund in terms of the return requirements. How do you think they could be improved?(3 marks)
(e)Analyse the objectives of the balanced fund in terms of risk management. How do you think they could be improved?(3 marks)
Criteria-based Marking Guide for Question 1(a)–(e)
Excellent (Mark range: 9–12 marks) Satisfactory (Mark range: 6–8.5 marks) Unsatisfactory (Mark range: 0–5.5 marks)
detailed analysis of objectives and their appropriateness for the DB fund in terms of return requirements and risk management
at least 4 suggestions on how the objectives of the DB fund could be improved
2 new well-structured objectives identified for DB fund
detailed analysis of objectives and their appropriateness for the balanced fund in terms of return requirements and risk management
at least 4 suggestions on how the objectives of the balanced fund could be improved basic analysis of objectives and their appropriateness for the DB fund in terms of return requirements and risk management
at least 2–3 basic suggestions on how the objectives of the DB fund could be improved
at least 1 new well-structured objective identified for DB fund
basic analysis of objectives and their appropriateness for the balanced fund in terms of return requirements and risk management
at least 3 basic suggestions on how the objectives of the balanced fund could be improved incorrect or no analysis of objectives of the DB fund in terms of return requirements and risk management
incorrect or no suggestions on how the objectives of the DB fund could be improved
poor or no new objectives identified for DB fund
incorrect or no analysis of objectives of the balanced fund in terms of return requirements and risk management
incorrect or no suggestions on how the objectives of the balanced fund could be improved
Insert your answers to Question SEQ Answers_to_Section_A:_Question * ARABIC 1(a)–(e) below this line
The stated objective of the defined benefit fund is to ensure capital is maintained over the short-term. This objective is motivated by the fact that the fund represents mostly aging members with no possibility of admitting new members. This objective does not describe how the fund intends to set an investment policy for allocating capital between various classes of assets. Besides, the objective does not explain how the fund’s liabilities are to be managed to achieve optimal returns. The challenges associated with estimating liabilities of defined benefit plans create an imperative for fund managers to focus on capital growth in the long-term. A long-term focus will yield sufficient knowledge which can be utilized to improve the fund’s returns and performance over the short-term. The objective can be improved by focusing on strategies for maximizing members’ returns (Fink, 2011).
The main risk arising from the defined benefit fund’s objective is that the short-term focus on capital growth will result in minimal retirement benefits especially for employees who live long after retirement. Ideally, some employees can live for up to three decades after retirement. With the fund’s short-term orientation, these employees will not be covered for a greater part of their post-retirement lives. Another risk is that the investment pegs the decision-making responsibility on short-term market conditions (Pozen & Hamacher, 2015). This means that if new long-term investment opportunities arise in the market, the fund will not take advantage of these opportunities because its focus is on short-term gains. In terms of risk management, the objectives of the fund can be improved by focusing on longer time horizon as opposed to the time-to-retirement of the current members. This will give the fund increased capacity to absorb any fluctuations in the market cycle.
Based on the return and risk requirements of the defined benefit funds, the following objectives are proposed:
To maximize members’ returns in the long-term by investing fund capital in high performing markets.
To reduce risks associated with fund growth due to the aging of members.
The balanced fund’s objectives are to maximize returns over 5-7 year periods, match returns of similar funds available in the marketplace over 3-year time frames, and grow at an annual inflation rate of +4% over 5-year periods. These objectives appear to be based on the need to improve the fund’s returns as much as possible. Thus, the objectives will most likely lead to a steady rise in the value of the fund. Since the fund seeks to maximize returns over short periods, it can introduce newer strategies for managing capital to ensure optimal returns throughout the lives of members. The fund has taken into account the effect of inflation, which is a major factor influencing the growth of pension funds. The objectives could be improved by focusing on diverse investment options as a way of maximizing the value of returns (Fink, 2011).
In its objectives, the balanced funds have emphasized the need to manage inflation-related risks. Inflation has the negative effect of reducing the amount of pension funds available to members. If inflation is high for a relatively longer period, members will not get enough returns as expected. By keeping the impact of inflation low, the fund has ensured that appropriate measures are put in place to check any harmful effects of inflation (Pozen & Hamacher, 2015). This will result in better returns for the members’ funds. The objective can be improved by introducing a ceiling on the level of pension increases that can be paid to members upon retirement. This way, high inflation will not reduce the value of pension that members get.
End of answers to Question SEQ End_of_answers_to_Section_A:_Question * ARABIC 1(a)–(e)
Question SEQ Question * ARABIC 2(8 marks | Word limit: 200 words)
LO1: Analyse the processes involved in managing an investment portfolio.
(a)Evaluate the strengths and weaknesses of the current process to select investment managers.(4 marks)
(b)Explain how you would improve the process, focusing your discussion on the selection of managers for the equity portfolio.(4 marks)
Criteria-based Marking Guide for Question 2(a)–(b)
Excellent (Mark range: 6.5–8 marks) Satisfactory (Mark range: 4–6 marks) Unsatisfactory (Mark range: 0–3.5 marks)
detailed evaluation of at least 3 strengths and weaknesses of current manager selection process
detailed discussion of at least 3 methods to improve the process of manager selection basic evaluation of 2 strengths and weaknesses of current manager selection process
basic discussion of 2 methods to improve the process of manager selection no or incorrect evaluation of strengths and weaknesses of current manager selection process
no or incorrect discussion of how the process of manager selection could be improved
Insert your answers to Question SEQ Answers_to_Section_A:_Question * ARABIC 2(a)–(b) below this line
The main strength of the current process of selecting investment managers is that the fund relies on the expert knowledge of consultants to get the best people. Often, consultants have in-depth knowledge of industry needs and the kind of skills and knowledge required to drive the fund’s strategic agenda. Moreover, recruiters have wider access to a large pool of managers with the right experience that can help the company to advance its strategic objectives. The main weakness is that the selection process only considers the prospective manager’s performance over the past five years. This duration is short for fund managers to understand pertinent issues related to pension fund management (Fink, 2011).
The selection process can be improved by focusing on managers with a global orientation regarding experience, knowledge, and skills. The global pension market has increased in complexity over the years. With the advent of innovative investment solutions, the requirements for successful management of equity portfolios continue to expand dramatically. For this reason, a candidate with an in-depth understanding of the various aspects related to pension management will be the best manager. The candidate should also have excellent analytical skills such as the ability to develop alternative solutions to achieve optimal portfolio results.
End of answers to Question SEQ End_of_answers_to_Section_A:_Question * ARABIC 2(a)–(b)
Question SEQ Question * ARABIC 3(30 marks | Word limit: 1700 words)
LO2: Explain the theoretical concepts underpinning investment management.
(a)The strategic asset allocation (SAA) of the balanced fund has been calculated using a mean variance optimiser with 10 years of past returns, volatility and correlation. As discussed in the IPS(Appendix 1), the SAA is recalculated every year using the past 10 years’ data for the major benchmarks in each sector, subject to peer related constraints.
Discuss the merits or weaknesses of this approach, with reference to:
(i)the assumptions underlying the mean variance approach to asset allocation, and therefore underlying this approach(3 marks)
(ii)the suitability of the data used, suggesting any changes you believe may be warranted(4 marks)
(iii)the method of calculating asset allocation and the constraints used, suggesting any changes you believe may be warranted.(3 marks)
LO4: Assess manager selection and portfolio management styles.
(b)Compare and contrast the approach currently being used in the balanced fund with arbitrage pricing theory (APT). Do you think APT is a valid approach for generating asset allocations? Do you think it could be used by the balanced fund? Justify your view.(10 marks)
Note: A description of APT is not necessary.
LO2: Explain the theoretical concepts underpinning investment management.
(c)The trustees are interested in behavioural finance but know very little about it. Explain how you think behavioural finance might impact each fund’s asset allocation. What benefits could behavioural finance insights provide the trustees when setting the objectives and strategic asset allocation for the funds?(10 marks)
Criteria-based Marking Guide for Question 3(a)–(c)
Excellent (Mark range: 25.5–30 marks) Satisfactory (Mark range: 15–25 marks) Unsatisfactory (Mark range: 0–14.5 marks)
clear and relevant discussion of the merits or weaknesses of the mean variance approach for recalculating the balanced fund SAA
clear integration into discussion of assumptions, suitability of data used and any changes warranted
clear integration into discussion of method of calculating asset allocation and constraints used
clear and logical discussion of changes considered to be warranted
thorough and logical explanation which integrates a clear conclusion about SAA approaches currently used in the balanced fund compared with APT
logical and well explained view provided on whether APT is a valid approach for generating asset allocations
logical and well explained view provided on whether APT could be used by the balanced fund
detailed discussion of how behavioural finance impacts each fund’s asset allocation
logical and detailed explanation of benefits of behavioural finance insights for trustees when setting the objectives and SAA for the funds some discussion of the merits or weaknesses of the mean variance approach for recalculating the balanced fund SAA
some discussion of assumptions, suitability of data used and any changes warranted
brief discussion of method of calculating asset allocation and constraints used
brief discussion of changes considered to be warranted
basic explanation with appropriate conclusion about SAA approaches currently used in the balanced fund compared with APT
logical view provided on whether APT is a valid approach for generating asset allocations
logical view provided on whether APT could be used by the balanced fund
brief discussion of how behavioural finance impacts each fund’s asset allocation
reasonable and logical explanation of benefits of behavioural finance insights for trustees when setting the objectives and SAA for the funds few or no merits or weaknesses of the mean variance approach for recalculating the balanced fund SAA discussed
little or no discussion of assumptions, suitability of data used and any changes warranted
little or no discussion of method of calculating asset allocation and constraints used
little or no discussion of any changes considered to be warranted
little or no explanation of SAA approaches currently used in the balanced fund compared with APT no or unclear conclusion
poor or no view given on whether APT is a valid approach for generating asset allocations
poor or no view given on whether APT could be used by the balanced fund
little or no discussion of how behavioural finance impacts each fund’s asset allocation
little or no explanation of benefits of behavioural finance insights for trustees when setting the objectives and SAA for the funds
Insert your answers to Question SEQ Answers_to_Section_A:_Question * ARABIC 3(a)–(c) below this line
Question Responses
The mean variance optimization approach is based on the assumption that returns follow a multivariate normal distribution with particular covariance and mean parameters. With this assumption, the results of the strategic asset allocation will be different investment portfolios with similar returns as per the degrees of freedom. The main strength of this approach is that it enables investment managers to identify at each level of return the combination of assets (portfolios) with the lowest variance and the optimal asset allocation for the particular portfolio (Fink, 2011). Thus, the approach leads to optimal returns with minimal variance, which is the objective of any investment decision. The main weakness inherent in the mean-variance optimization approach is that in the long-run, there is no risk-free portfolio that meets the assumption of multivariate normal distribution of returns. Indeed, no asset is likely to have a zero standard deviation or correlation. Therefore, in an ideal situation, the mean-variance optimization approach requires constant borrowing to enable the portfolio to maintain a leveraged performance in the market.
The mean variance optimization approach is based on historical data with the assumption that portfolio performance is normally distributed in the long-term. In this case, the strategic asset allocation has been calculated using data from a ten year period. The strength of this approach is that it gives fund managers increased the ability to make corrections based on the historical performance of the portfolio in the past. Moreover, the returns of the portfolio over the ten year period can be compared to the performance of similar portfolio to identify trends and any issues that should be taken into account to optimize the allocation decisions. A major issue relating to this approach relates to the selection of optimal data for the optimizer (Pozen & Hamacher, 2015). By using historical data, the mean variance optimizer assumes that portfolio performance during the upcoming period will be the same as the past ten years. This is not always the case since market conditions are affected by a wide range of factors which determine the actual performance of portfolios. For example, a global credit crunch may have a huge impact on a particular portfolio, thereby making use of historical data less impressive. As a matter of fact, a credit crunch may cause a phenomenon referred to as mean reversion, whereby a period of superior portfolio performance is followed by a period of inferior performance and vice versa. It is, therefore, appropriate to take into account the wider market conditions when using the mean-variance optimizer instead of just the historical data.
The mean variance optimizer is constrained within past ten years of returns, correlations, and volatility. These constraints have the merit of minimizing errors in the estimated mean of the portfolio and its returns. For instance, if the fund portfolios believe that the portfolio returns in different investment periods to be identically and independently distributed, they will of necessity use historical data to estimate the statistical properties of the portfolio’s anticipated future performance. In effect, the level of expected return assigned to various portfolios will most likely be over-estimated, which will cause discrepancies in the standards deviation of the strategic asset allocation.
The arbitrage pricing theory (APT) is an investment model used to align an incorrectly priced asset with its actual value. The theory is based on the reasoning that the future returns of a portfolio or asset can be predicted accurately by zeroing on the relationship between the portfolio and its risk factors. In essence, the fundamental idea behind the arbitrage pricing theory is that returns on an asset can be explained by the prevailing macroeconomic factors as well as the sensitivity of the asset to each macro-economic factor (Bodie, Kane & Marcus, 2005). For any asset and in whichever market, there is a wide range of macro-economic factors which influence returns. These include exchange rates, investor confidence, interest rates, inflation, and production indices. Compared to the balanced fund, the arbitrage pricing theory is more flexible because it allows investors to adapt their investment decisions to the specific attributes of the security being analyzed. Most importantly, the model allows investors to decide whether an asset is overvalued or undervalued. This information is highly valuable for building investment portfolios with high returns and low risks.
As an investment model, the arbitrage pricing theory differs from the balanced fund in that the latter gives capital more exposure to both debt and equity instruments. It is thus the best facet with low risks and high returns. In the equity-oriented balanced fund, a great part of capital is committed to equity instruments with the rest being invested in debt. This results in safe investment instruments with a high probability of good returns. An important consideration about the balanced fund is that it promises optimal results from both equity and debt investments. The potential for maximum returns from equity are as attractive as the debt component (Fink, 2011). Thus, balanced funds have low volatility in both the short-term and long-term. In addition, the returns obtained from balanced funds are risk adjusted, which is not the case with arbitrage pricing theory. The risk adjustment factor in balanced funds is determined by how fund managers decide to allocate the assets. If small and mid-cap assets are selected, the gains of the equity component are considerably higher, and any associated risks can be checked by the debt capital. This means that it is impossible for fund managers to minimize risk further by settling on small cap stocks only.
For investments focused on the long-term, the arbitrage pricing theory offers the advantage of more customizability than the balanced fund. However, the arbitrage pricing theory is more difficult to apply because a lot of research is required to determine the specific factors that affect stock performance. In a typical market, it can be almost impossible to account for each and every factor and hence one cannot determine how sensitive the security is to particular factors. Arbitrage pricing theorem only offers the advantage of getting close enough to understanding the specific factors influencing portfolio performance (Pozen & Hamacher, 2015). For example, adverse trends relating to inflation, shifts in the yield curve and gross national product may have an effect on stock in the long run. However, these will not be the only factors. The balanced fund eliminates this difficulty by giving investment managers an option of focusing either on equity or debt. If the fund is long-term and equity focused, then a greater part of the investment can be expected to be exempt from the long-term tax levied on capital gains. If debt was focused, there are indexation benefits if the investments is held for periods longer than the year. This makes balanced funds an attractive tax saving investment compared to the arbitrage pricing theory.
(c)Behavioural finance is a new development in the fields of finance and research that looks at the psychological factors influencing investment decisions. This theory attempts to describe anomalies in the market that have not been explained by alternative theories such as the efficient market hypothesis. The central premise of psychological finance is that behavioural biases affect investors’ decisions by distorting or limiting information, which causes investors to reach inaccurate conclusions. The behavioural biases can be divided into two main categories: emotional factors and misinformation errors. Emotional factors are critical because they override intelligence when making decisions. As a matter of fact, the investor may be carried by emotions to give too much consideration to factors that appear attractive and ignore those that are not in one’s predisposition. Regret avoidance (the fear of regrets) is the greatest emotional factor influencing investment decisions. It may cause investors to avoid debt instruments in the fear that they may not become profitable. Other important emotional factors include belief perseverance, conservatism, overconfidence and degree of loss aversion.
According to Bodie, Kane, and Marcus (2005), thinking errors and misinformation are important psychological factors that account for market inefficiencies. This is because no investor knows everything about the market. Even if the investors knew everything about the market, they might not necessarily make the best decision based on that information alone. Forecasting errors are the most common example of misinformation errors that distort investment decisions. Stock analysts may be wrong about future movements in stock earning as well as prospects for positive movements in asset values. This could be due to the effects of narrow framing, a situation where a small number of factors are evaluated for the investment decision. For example, a certain security may appear preferable because of its performance in the past without taking into account current and future economic factors that may impact the performance of the security.
Behavioural finance will have an impact on both the balanced fund and the defined benefit fund. With regard to the balanced fund, behavioural finance refutes the assumption of rational investors and market efficiency. Therefore, investors make decisions based on the rules of behavioural portfolio theory and not the variance portfolio hypothesis (Pozen & Hamacher, 2015). For the balanced fund, expected returns will be strongly influenced by the behaviours of the fund managers, particularly with regard to how they perceive the market. If the managers believe that the investment may not yield optimal returns, they will avoid it. The downside is that market conditions do change frequently, but since fund managers will have already made a decision, any future improvements in market conditions will be ignored.
Behavioural finance will have an effect on the defined benefit fund through reluctance to account for losses through hindsight bias. Due to the existence of misleading information, fund managers are likely to base their decisions on hindsight bias. The implication is that the fund managers will be misled to think that they had the ability to foresee asset performance in foresight and avoid them. This creates a cognitive bias that is linked to the fear of regret. If the fund incurs losses, managers will have the pain of regretting when it turns out that better outcomes could have been realized by avoiding the losing decisions.
End of answers to Question SEQ End_of_answers_to_Section_A:_Question * ARABIC 3(a)–(c)
Question SEQ Question * ARABIC 4(50 marks | Word limit: 2500 words)
LO3: Apply the process of asset allocation and portfolio construction.
(a)The trustees of ABC have now asked you to consider alternative approaches to asset allocation. Consider the strategic asset allocation (SAA) for the defined benefit fund (as set out in Appendix 2).
(i)Assess three (3) strengths and three (3) weaknesses of the current SAA, including the approach to setting the SAA and the ranges for each asset class. (6 marks)
(ii)Provide a rationale as to whether this allocation is appropriate given the objectives as they are currently expressed.(2 marks)
(iii)Is the SAA appropriate for the two new objectives you formulated in Question 1(c)? Explain why or why not. Recommend improvements that will increase the probability of your formulated objectives being reached.(8 marks)
(iv)Propose an alternative approach to setting the SAA for the defined benefit fund and discuss why you think it would be superior to the current approach. Provide reasons and evidence to support your view. (Include in your discussion theoretical underpinnings and frequency of review.)(9 marks)
(b)The asset allocation policy for the defined benefit fund is silent on the use of active asset allocation (AAA), which is an approach whereby the fund would vary asset allocation, rather than maintain a fixed or strategic asset allocation (SAA).
(i)Discuss the benefits and disadvantages of the AAA approach in general. (5 marks)
(ii)Do you think AAA should be permitted in the defined benefit fund? Provide reasons for your answer.(5 marks)
(iii)Consistent with, or against, your advice, the trustees decide to adopt AAA in the asset allocation policy for the defined benefit fund. Provide the trustees with advice on how best to implement AAA.(5 marks)
(c)The trustees have asked you to also review the strategic asset allocation (SAA) for the balanced fund.
(i)Propose what you consider may be a more appropriate approach for determining the fund’s SAA. Explain why your suggested approach is more appropriate. (8 marks)
(ii)Propose guidelines as to how often the SAA should be reviewed.(2 marks)
Note: Your answers to part (c) may include approaches previously considered in this assignment.
Criteria-based Marking Guide for Question 4(a)–(c)
Excellent (Mark range: 38–50 marks) Satisfactory (Mark range: 25–37.5 marks) Unsatisfactory (Mark range: 0–24.5 marks)
thorough and logical analysis of the strengths and weaknesses of the current SAA. Logical rationale as to the appropriateness of the SAA given the current objectives
excellent and logical arguments as to the suitability of the SAA to the 2 new objectives formulated in Question 1(c)
well thought out recommendations for improvements
excellent and logical proposal for alternative approach to setting SAA for the DB fund
solid theoretical underpinnings and integrating wider research and evidence provided
thorough and logical discussion of the benefits and disadvantages of the AAA approach providing a clear statement as to the suitability of AAA for the DB fund with excellent reasons
clear recommendation with well thought out reasons as to how to implement AAA
detailed and logical explanation of an appropriate approach to determining the SAA for the balanced fund reasonable analysis of the strengths and weaknesses of the current SAA. Some rationale as to the appropriateness of the SAA given the current objectives
adequate arguments as to the suitability of the SAA to the 2 new objectives formulated in Question 1(c)
adequate recommendations for improvements
adequate proposal for alternative approach to setting SAA for the DB fund
some theoretical underpinnings and external evidence provided
adequate discussion of the benefits and disadvantages of the AAA approach providing a clear statement as to the suitability of AAA for the DB fund with adequate reasons
clear recommendation with adequate reasons as to how to implement AAA
reasonable and logical explanation of an appropriate approach to determining the SAA for the balanced fund insufficient or incorrect analysis of the strengths and weaknesses of the current SAA. Little or no correct rationale as to the appropriateness of the SAA given the current objectives
poor or incorrect arguments as to the suitability of the SAA to the 2 new objectives formulated in Question 1(c)
few or no recommendations for improvements
poor or incorrect proposal for alternative approach to setting SAA for the DB fund
insufficient theoretical underpinnings and external evidence provided
insufficient or incorrect discussion of the benefits and disadvantages of the AAA approach
no clear statement as to the suitability of AAA for the DB fund or inadequate or incorrect reasons
no clear recommendation as to how to implement AAA or inadequate or incorrect reasons
poor or unclear explanation of an appropriate approach to determining the SAA for the balanced fund
Insert your answers to Question SEQ Answers_to_Section_A:_Question * ARABIC 4(a)–(c) below this line
Question responses
Strategic asset allocation (SAA) is a portfolio building approach in which fund managers attempt to balance the amount of capital that should be committed to different categories of investments. Once the allocation has been determined, it is adopted for several years and is rarely changed. The basis of this investment strategy lies in the assumption that markets are efficient and that in the long-run, inefficiencies in the market will be eliminated. The current SAA strategy for ABC is based on a conservative approach because the average age of members is above 40. In this regard, asset allocations are defined each year using the average asset allocations of peer funds. Under this approach, investments in Australian fixed interest get the highest allocation while equities get the lowest allocation.
The main strength of the above SAA strategy is that it ensures that the overall risks of the portfolio do not drift higher than expected. Since investments in Australian fixed interests have low levels of risks, they are given the highest allocation. The second strength is that the strategic allocation strategy allows fund managers to take advantage of buy-low, sell high opportunities in the market. Lastly, annual rebalancing allows for smoothing of risks in long-term investments. Regarding weaknesses, the frequent rebalancing leads to unnecessary transaction costs for the fund. Secondly, it is not clear that rebalancing annually is enough to achieve the optimal goals of risk reduction. Third, downturns in the domestic economy will severely impact returns from the portfolio. This is because of the apparently large proportion allocated to the domestic market (Fink, 2011).
Given the objectives, as they are currently set, the strategic asset allocation is not appropriate. This is because the annual rebalancing of the asset allocation allows for portfolio allocations to drift gradually. In the long run, this drifting will trigger a big rebalancing trade off if the desired threshold is not reached. If investments in each asset class grow in line with the set objectives and their relative weights are not changed adversely, no major rebalancing will be needed. However, this is not likely to be the case because of the class of assets is exposed to different risks depending on the prevailing market conditions. Adverse market conditions will have the effect of breaching the rebalancing tolerance bands. For this reason, only those investments that cross the projected line can be sold or brought to bring them within their respective bands. To avoid this risk, ABC’s strategic asset allocation process and portfolios should be monitored actively so that managers can know when a threshold level has been reached.
The strategic asset allocation approach is appropriate for the objectives formulated in Question 1(c) for two main reasons. First, the SAA serve the critical function of keeping the various asset categories targeted to the appropriate levels of risks as dictated by prevailing market conditions. Since market imperfections are the norm, long-term portfolios with higher returns would be weighted fairly by having the lower risk out-compounded in the portfolio (Pozen & Hamacher, 2015). In the short-term, this rebalancing presents opportunities for the portfolio to generate better returns in accordance with the recommended objectives. This will be particularly the case when rebalancing of investments with same levels of returns is the most viable investment option. In effect, the goal of the investment option is to determine specific investment portfolios whose returns have moved to extreme levels and initiate a new rebalancing trade and have the investment bought or sold before reverting towards the long-term average.
To improve the probability of the recommended objectives being reached, it is recommended that fund managers consider doing the rebalancing more frequently. This will among other benefits result in increased ability to identify investments that are likely to have a big run of outperformance. In turn, this will trigger a significant level of returns before each year’s gains have occurred. Similarly, if the portfolio’s returns were to decline in a persistent market crash, rebalancing more frequently will enable investors to make more investments by purchasing more shares to offset the subsequent decline of the investment value (Bodie, Kane & Marcus, 2005). It is also recommended that fund managers put in place strategies for ensuring that at least one investment portfolio receives significant relative outperformance that extends for a longer period, preferably a year. This will curtail any negative momentum in portfolio performance and add quickly into the negatives. An additional benefit is that more frequent rebalancing will can grind the long-term benefits of having to rebalance just to minimize transaction costs. Furthermore, since the number of asset classes is big, the number of investment cycles that should be optimized is also increasing. This puts returns from the investment portfolios in sync with each other, which is critical for overall investment performance in the long-term.
It is proposed that the fund adopts the opportunistic rebalancing approach in setting the SAA for the defined benefit fund. The rationale behind opportunistic rebalancing is to monitor the investments more frequently but only make a rebalancing decision when it is optimal and more profitable to do so. Under the current SAA strategy, the rebalancing is done once a year and only when it looks fit to do so. This is inefficient because short-term market trends are hardly accounted for. It is far better and profitable for the rebalancing time frame to be narrowed down and made more frequent so that slight changes in market conditions can be monitored and decisions made whether the rebalancing is necessary. Effectively, the fund will be able to react positively to current information rather than having to guess what the situation will be at the end of the investment cycle. For example, if stock prices change adversely, the defined benefit fund will have good chances of mitigating risks in a timely manner.
Doyle, Hill and Jack (2007) argue that opportunistic rebalancing is ideal for mitigating risks in defined benefit funds because it allows for stock portfolios to be rebalanced within the tolerance band instead of the initial allocation. Thus, if a particular stock’s returns lie outside the threshold, rebalancing becomes the only viable option. This means that there is a high likelihood that not each and every stock will need to be rebalanced within any one year, which minimize the number of trades required to effect the rebalancing exercise. In essence, the tolerance bands provide optimal flexibility for portfolio returns to oscillate freely without any major issues while containing adverse risks, thereby acting as a buffer for filtering out any unprofitable rebalancing activities. It can be noted that opportunistic rebalancing works best for shorter frequencies and portfolios spread over wider market conditions. In ideal situations, if the tolerance band is set above 50% and threshold levels below 20%, the returns will be optimized and risks kept minimum.
Question Responses
Active Asset Allocation (AAA) is an alternative approach to managing portfolios to ensure maximum returns and minimum risks. It refers to an actively monitored and diversified fund whose aim is to achieve high stock performance from a diversified portfolio comprising of government bonds, global equities, cash, property shares and other alternative investments. Common alternative investments include in infrastructural development, agriculture and precious metals such as diamond and gold. To arrive at optimal allocation levels, the fund management team conducts the asset allocation on an ongoing basis (Dimson, Marsh & Staunton, 2009). This means that active asset allocation can change every so often because investments are allocated in accordance with current data. A key benefit of active asset allocation is that when implemented well, it can reduce a fund’s exposure to gradually or rapidly declining markets by preserving capital and most of whatever has been gained previously. For a defined benefit fund, moving out of the prior market means that the fund has extra money to invest in more portfolios when the market moves upwards. This is to say that the strategy of active asset allocation can result in optimal returns over a complete market cycle.
Another benefit of active asset allocation strategy is that it allows for mispriced securities to be sold or bought at the right market price, leading to optimal returns. Active fund managers devote most of their time and resources trying to find best levels of asset allocation that will yield best returns. Common strategies are studying the company’s past performance, review of latest industry releases and forecasting based on interest rate movements as well as corporate earnings. In essence, active asset allocation can be used in minor classes of securities for markets where benchmark securities do not represent the market well. Lastly, active asset allocation is not affected by liquidity constraints and therefore it allows for the use of more liquid indices. Bodie, Kane and Marcus (2005) explain that indices implemented by defined benefits fund managers are associated with low risk-adjusted returns in the long-term. In other words, leveraging funds through active asset allocation does not require beating benchmarking in order to outperform average market returns.
The main disadvantage of active asset allocation is that the approach fails to take into account the possibility of market capitalization diminishing the likelihood of fund growth and size. Although individual portfolios might not be as broad compared to the market’s standard cap index, the equal weighting technique used in active asset allocation dilutes risks of stock decline due to mechanical rebalancing.
Active asset allocation should be permitted into the defined benefit fund for two main reasons. First, it facilitates maintenance of high levels of asset allocation and asset allocation. According to Doyle, Hill and Jack (2007), the long-term returns of the defined benefit fund enable members to be interested in the project during the period for which returns are being assessed. Regardless of whether the fund is active or indexed, returns will always be high as long as fund managers monitor it actively. Experienced fund managers with proven experience in mitigating risks during periods of economic downturns will promote high levels of investment discipline and the related asset allocation. The ability of active asset allocation to keep members of the course is an important factor for its inclusion in the defined benefits fund.
Secondly, the strategy of active asset allocation brings more opportunities for outperformance. Investing in defined benefits fund enables members to get results as close to the indexed performance as possible. The most important thing for fund managers to consider before including active asset allocation in a defined benefit fund is whether the set benchmarks are attractive for benchmarking. Essentially, passive investment strategies have to accommodate any shortcoming that comes in the way of the fund. Since defined benefit funds are actively managed, including active asset allocation does not result in any major challenges.
If the trustees decide to adopt active asset allocation in their policy for the defined benefit fund, the most important thing they can do is to implement a strategy for optimizing marketing timing and security selection. Evidence shows that on average, defined benefit funds are capable of adding value above their indexed policy returns (Dimson, Marsh & Staunton, 2009). This is consistent with the expectations that pension funds, in general, outperform most active portfolios in bond and equity portfolios. Therefore, by optimizing security selection and market timing, the trustees will secure a growing stream of future returns from the defined benefit. Another that the trustees should do is to implement a plan for risk management. Including active asset allocation in a defined benefit fund is a highly risky decision although it can result in good returns. Active risk management makes it easier for fund managers to accept reduced returns if prospects for improvements in future performance are high. In effect, risk management will enable the trustees to adopt a defensive stance so as to ameliorate exposure and protect capital during periods of market downturn. This means that any active asset allocation policies should be geared towards overall risk reduction as long as funds remain reliant on optimized market timing.
Question Responses
The most appropriate approach for determining the balanced fund’s strategic asset allocation is to focus on portfolios with optimal returns. This approach will among other things require fund managers to consider the issue of liabilities. In order to minimize risks, the investment horizon should not exceed a year. In addition, the opportunity set should consist of various asset classes (Doyle, Hill & Jack, 2007). With all these factors taken into account, the fund managers should focus on maximizing wealth as the primary investment goal. The fund managers can solve the problem of asset allocation by optimizing the mean and variance of returns from the investment based on expected returns. The goal here is to maximize risk-adjusted returns on the balanced fund. This approach is appropriate because it will give fund managers an opportunity to focus on striking a fair balance between the fund’s solvency capital requirement and the portfolio composition. Ideally, the capital requirement should be a pre-determined percentage of the fund’s liabilities taking into account technical provisions. This will make the difference between the behavior of liabilities and assets to be in tandem with the fund’s long-term growth objectives.
Reviewing is a disciplined way of ensuring that a portfolio is in line with the strategic targets. Reviewing helps in ensuring that funds are committed into the most attractive portfolios, and that is the best way of minimizing a portfolio’s returns and increasing risks. Regarding the frequency of reviewing, it is recommended that it should be done on an annual basis (preferably at the end of the calendar year). The main advantage of making annual reviews is that it allows for fund managers to be systematic about containing losses related to tax and gains so as to improve overall fund performance (Amin & Kat, 2005). An important issue that should be taken into account when doing annual reviewing is that on some calendar year schedules, the fund may incur increased transaction costs. Therefore, the reviewing should be done only when the fund’s stakes in cash or bonds are within a manageable variance from the target ranges. Certain investment policies for strategic asset allocation include a breakdown of the portfolio into sub-asset categories. In such a case, it is possible for reviewing to be done more than once a year, preferably every six months. Reviewing twice a year will create more opportunities for the fund managers to set the risk exposure of the fund to the broad class of assets. In turn, this will keep the portfolio in line with the most important parameters.
End of answers to Question SEQ End_of_answers_to_Section_A:_Question * ARABIC 4(a)–(c)
End of Assignment

References
Amin, G. & Kat, H. (2005). Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias A1994-2001. Journal of Alternative Investments, 6(2), 57-73.
Bodie, Z., Kane, A. & Marcus, A. (2005). Investments. Boston: McGraw-Hill.
Dimson, E., Marsh, P. & Staunton, M. (2009). Global Investment Returns Sourcebook 2009. Adelaide: Credit Suisse.
Doyle, E., Hill, J. & Jack, I. (2007). Growth in Commodity Investment: Risks and Challenges for Commodity Market Participants. New York: FSA Markets Infrastructure Department.
Fink, M. (2011). The Rise of Mutual Funds: An Insider’s View. Oxford: Oxford University Press.
Pozen, R. & Hamacher, T. (2015). The Fund Industry: How Your Money is Managed. Hoboken, NJ: Wiley Finance.
Appendix 1: Investment policy statement — balanced fund
This investment policy statement serves three purposes:
1.to set objectives
2.to define the asset allocation policy
3.to establish guidelines for choosing investment managers.
Objectives of the balanced fund
The fund objectives are:
•to maximise returns over 5–7 year periods
•to match the returns of similar funds available in the market place over 3-year time frames
•to grow at inflation + 4% p.a. over 5-year rolling periods.
Asset allocation policy
Asset allocation is set in the following way:
•As we believe markets are generally efficient and that the assumptions of the Efficient Market Hypothesis and Modern Portfolio Theory hold true, we adhere to a mean variance optimisation approach to determine asset allocation.
•Strategic asset allocations are set each year using mean variance optimisation and the preceding 10 years of historical returns, variance and correlations for the major asset classes.
•The following ranges are used for asset allocation and act as our constraints when using the mean variance optimiser. These are updated annually and are determined through an annual survey of peers. This ensures that our position does not deviate significantly from peers and our performance should not differ significantly.
Minimum Maximum
Australian equities 35 45
International equities 25 35
Australian fixed interest 10 20
International fixed interest 10 20
Property — Australian —listed and direct 5 10
Global property —listed 0 5
Alternatives including hedge funds, infrastructure, private equity 0 10
Cash 5 15
Choosing managers
In choosing fund managers we use the following guidelines:
•A-rated from our current global investment consultant
•outperformance over the relevant benchmark over the past five years
•a style that is complementary to our existing portfolio
•equity portfolios that have a ‘value’ style bias.
Appendix 2:Investment policy statement — defined benefit fund
This investment policy statement serves three purposes:
1.to set objectives
2.to define the asset allocation policy
3.to establish guidelines for choosing investment managers.
Objectives of the defined benefit fund
As the fund represents a broad array of aging members with no new members being permitted, the most appropriate objective for the fund is to ensure capital is maintained over the medium term.
Asset allocation policy
The strategic asset allocation is set in the following way:
•As the average age of fund members is above 40 a conservative asset allocation is adopted.
•Strategic asset allocations are set each year using the average asset allocation of peer group funds (sourced through word of mouth).
•The fund uses tight asset allocation tolerance bands and rebalances whenever the ranges are breached.
Minimum Maximum
Australian equities 5 10
International equities 5 10
Australian fixed interest 45 50
International fixed interest 15 20
Property — Australian —listed and direct 10 15
Cash 10 15
Choosing managers
In choosing fund managers we use the following guidelines:
•A-rated from our current global investment consultant
•outperformance over the relevant benchmark over the past five years
•a style that is complementary to our existing portfolio
•equity portfolios that have a ‘value’ style bias.
End of Appendices