2019 CFA level 3 finquiz curriculum note, study session 3, reading 5

Overview of the Asset Management Industry and Portfolio Management INTRODUCTION The asset management industry serves as a critical link between providers and seeker of investment capital across the globe The industry provides professional The Asset Management Industry North America and Europe manage the largest proportion of global assets while the assets markets of Asia and Latin America are the fastest growing 2.1 Industry Overview The estimated global investable capital market size has grown The universe of firms in the industry is broad and include: • • • • pure-play independent asset managers, diversified commercial banks, insurance companies, and brokerages Clients are diverse in nature and include: • • • • investment services for a diverse client base with varying objectives and risk tolerances large multinational corporations, sovereign wealth funds, public funds meeting employee pension obligations, and individual investors planning for retirement Asset managers offer a broad range of strategies Specialist managers focus on a specific asset class or style A multi-boutique firm owns several investment firms each with their own specialized investment strategy 2.3 Traditional versus Alternative Asset Managers Asset managers are categorized as either traditional or alternative: Traditional Managers Focus on long-only equity, fixed-income and multi-asset investment strategies Alternative Managers Focus on private equity, hedge fund, and venture capital strategies Generate most revenue from asset-based management fees Generate revenue from asset-based management fees Have a higher proportion of global assets under management and generate a low total of industry revenue have lower proportion of global assets under management and generate a high total of industry revenue Difference between the two categories is becoming blurred as traditional managers are offering highermargin products to clients and alternative managers offer a retail version of their institutional alternative strategies or liquid alternatives and long-only investment strategies • 2.2 Active versus Passive Management Asset managers offer either active management or passive management or both Active management exceeded passive management in terms of global assets under management and industry revenue 2.4 Liquid alternatives are offered through regulated pooled vehicles and feature less leverage, no performance fees, and more liquidity compared to alternative products Ownership Structure Passive managers attempt to replicate the returns of the market index The market share of passive management has risen but its share of industry revenue remains small given low management fees relative to active management The majority of asset management firms are privately owned by individuals Privately owned companies are structured as limited liability companies or limited partnerships Private equity firms take a stake in privately owned asset management firms and engage in management buyouts Smart beta strategies: involve the use of simple, transparent, rules-based strategies as a basis for investment decisions They have higher management fees and higher portfolio turnover compared to passive, market-cap weighted strategies Publicly traded asset managers are less common than privately owned managers but have more assets under management –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com.All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading Reading 2.5 Overview of the Asset Management Industry and Portfolio Management Asset Management Clients Clients are divided among institutional and individual (retail) Investment strategies are offered to individuals via highly regulated pooled vehicles such as mutual funds Institutional-focused managers package investment strategies in less regulated and more customizable product structures such as separately managed accounts and limited partnerships Products are directly marketed to institutions or their investment consultants 2.5.1) Individual/Retail Investors The largest SWFs are concentrated in Asia and in natural resource-rich countries 2.5.2.3) Banks Banks are financial intermediaries that accept deposits and lend money Banks’ excess reserves are often invested in conservative and short-duration fixed-income investments They seek to earn an excess return on investments > interest obligations due to depositors Liquidity is important for banks as they are required to meet depositor requests for withdrawals Large banks often have asset management divisions offering retail and institutional products to their clients Asset managers distribute products directly to investors through financial advisers and/or retirement plans Distribution network for individual investors varies globally: FinQuiz.com 2.5.2.4) Insurance Companies Insurance companies include two types: life insurers and property and casualty (P&C) insurers Insurance Company’s General Account: • • • • US: Financial advisers are independent or employed by broker-dealers, banks and trust companies Many asset managers distribute investment strategies to investors through major online brokerage and custodial firms UK: Products are sold to independent advisers Asian countries: Distribution is dominated by large regional banks and global banks with private banking divisions Global: High-net-worth individuals are targeted 2.5.2) Institutional Investors 2.5.2.1) Pension Plans Pension plans are categorized as defined benefit (DB) or defined contribution (DC) Plan sponsors favor DC plans due to lower risk for the company DB plans are losing market share to DC plans but remain sizeable sources of funds for asset managers Geographical distribution: • • • US, UK and Japan comprise the largest proportion of global pension assets US and Australia have a higher proportion of assets in DC plans Canada, Japan, the Netherlands, and the UK are weighted towards DB plans • • • The account comprises of insurance premiums from policy holders The account is required to be invested conservatively in a diverse range of fixedincome securities Portfolio allocations of the account differ among life, P&C, and other specialty insurers because of the varying duration of liabilities and unique liquidity considerations Insurance Company’s Surplus Account: • • • Difference between assets and liabilities Typically targets a higher return than the general account Invests in less conservative asset classes such as public and private equities, real estate, infrastructure and hedge funds Many insurance companies have in-house portfolio management teams for managing general account assets Some insurance companies offer portfolio management services and products in addition to their insurance offerings Insurers increasingly outsource their portfolio management responsibilities to unaffiliated asset managers Insurers may also manage investments for third-party clients 2.5.2.2) Sovereign Wealth Funds (SWFs) 2.5.2.5) Endowments and Foundations SWFs are state-owned investment funds or entities that invest in financial or real assets SWFs not manage a specific liability obligation (s) and have varying investment objective and constraints based on investor’s goals Endowments and foundations allocate a sizeable portion of their assets to alternative investments The large allocation to endowments and foundations reflects their long-term horizon Reading 2.6 Overview of the Asset Management Industry and Portfolio Management o Major Investment Products 2.6.1) Mutual Funds Mutual funds are a primary investment product of individual investors globally Advantages of mutual funds include: • • • • low investment minimums diversified portfolios daily liquidity standardized performance and tax reporting 2.6.2) Separately Managed Accounts (SMAs) SMAs are managed for the benefit of an institution or individual Large institutional investors are the largest users of SMAs Private equity and venture capital funds seek to buy, optimize and later sell portfolio companies to generate profits They have a lifespan of 7-10 years approximately and take a hands-on approach to their portfolio companies The majority of private equity and venture capital funds are structured as limited partnerships Limited partnership exist between the fund manager (or general partner) and fund’s investors (or limited partners) Revenue/fees of funds include: • • 2.6.3) Exchange-traded Funds (ETFs) ETFs are investment funds that: • • • • trade on exchanges and are structured as open-end funds, enhance tactical decision-making as they are priced intraday and can be sold short, represent the fastest growing investment product in asset management industry, and are used by investors to build diversified portfolios 2.6.4) Hedge Funds Hedge funds are often used by investors for portfolio diversification purposes Hedge fund strategies are diverse Hedge fund characteristics include: Traditionally hedge funds have charged AUM fees of 2% and incentive fees of up to 20% 2.6.5) Private Equity and Venture Capital Funds SMAs enable managers to implement strategies that matches an investor’s specific objectives, portfolio constraints and tax considerations • FinQuiz.com • 2.7 Management fees: based on committed capital (or net asset value or invested capital) and range from 1-3% annually Fees may decrease some years after investment Transaction fees: paid by portfolio companies to the fund for corporate and structuring services A percentage of the transaction fee is shared with LPs offsetting the management fee Carried interest: GP’s share of profit (usually 20%) on sale of portfolio companies which they usually don’t receive until LPs recover their initial investment Investment income: Includes profits generated on capital contributed to the fund by the GP Asset Management Industry Trends Three key trends in the asset management industry as discussed in this section 2.7.1) Growth of Passive Investing • • • • • Short-selling: Short positions are established directly or synthetically using derivatives such as options, futures, and credit default swaps Absolute return seeking: often seek positive return in all market environments Leverage: Rely on financial leverage (bank borrowing) or implicit leverage (using derivatives) The use and amount of leverage depends on the investment strategy implemented Low correlation: Historically, some hedge funds have demonstrated a low correlation with equity and/or fixed-income asset classes Fee structures: Hedge funds charge the following fees: o Traditional asset-managementbased fee (AUM fee): o Incentive (or performance) fee: The growth of passive investing is attributed to low cost for investors as management fees for index funds are only a fraction of those for active strategies as well as the fact that efficiently priced markets make it difficult for active asset managers to generate ex ante alpha 2.7.2) Big Data in the Investment Process The digitization of data and exponential increase in computing power and data storage capacity have expanded additional information sources for asset managers Massive amount of data containing information of potential value to investors are created and captured daily which includes structured and unstructured data Reading Overview of the Asset Management Industry and Portfolio Management Asset managers are relying on advance statistical and machine learning techniques to help process and analyze new sources of data Third-party vendors also supply a vast amount of new data for asset managers New popular sources of data include: • • social media data: real-time media and content outlets provide meaningful market and company-specific announcements for investors and asset managers and imagery and sensory data: satellite imagery and geolocation devices provide vast real-time data to investment professionals Robo-adviser platforms range from exclusively digital investment platforms to hybrid platforms which offer digital investment advice and the services of a human financial adviser Rapid growth in robo-advisory assets is driven by: • • Asset managers and investment market participants are participating in an information arms race and managers must discover data with predictive potential and so faster than fellow market participants Substantial investments are required to convert structured and unstructured data into alpha generating and securitylevel decisions FinQuiz.com • 2.7.3) Robo-Advisers: An Emerging Wealth Management Channel Growing demand from mass affluent and younger investors: The efficiency of roboadvisory and scalability of technology means that customized but standardized investment advice can be offered to a wide range and size of investors Lower fees: Robo-advisors charge lower fees compared to traditional investment advisors In addition, robo-advisors use low fee underlying portfolio investment options such as ETFs or index funds when constructing client portfolios New entrants: Due to low entry barriers, large wealth management firms have introduced robo-adviser solutions to service certain customer segments and appeal to a new generation of investors Insurance companies and asset managers are also developing roboadviser solutions Robo-advisers are technological solutions which provide wealth management services such as investment planning, asset allocation, tax loss harvesting and investment strategy selection The Portfolio Management Process The portfolio management process includes the construction and monitoring of an asset owner’s or asset manager’s portfolio The process: • • • • • applies regardless of whether the asset manager relies on an external party to make the investment decision or otherwise makes decisions internally; the process rests on a foundation of good investment governance and includes assignment of decision-making responsibility to qualified individuals portfolio management process must reconcile asset owner objectives with possibilities offered by the investment opportunity set begins understanding asset owner’s (individual or institution) entire circumstances, objectives, constraints, and other preferences combines client circumstances with capital market inputs to construct portfolios This further aids in making passive and active investment decisions Portfolio managers need to consider the following: • • • • • • • The financial goals of clients The client’s financial resources (income and assets) The client’s financial obligations (expenses and liabilities) The client’s entire economic balance sheet including conventional and nonconventional assets and liabilities How client assets are invested – clients manage a portion of assets themselves or rely on more than one advisor Client-specific constraints such as taxes and liquidity Risk tolerance of clients The IPS is then created which represents a summation of circumstances, constraints, objectives, and policies that govern the relationship between the portfolio manager and the client Reading Overview of the Asset Management Industry and Portfolio Management To determine the strategic asset allocation for a client’s portfolio, managers must consider capital market expectations (CME) for proper structuring of the portfolio CME represent the macro expectations concerning risk and return of asset classes Insights from CME can help form micro expectations in security selection and valuation Governance ensures that: • assets are invested to achieve the asset owner’s investment objectives within the asset owner’s risk tolerance and constraints and in compliance with all applicable laws and regulations decisions are made by individuals or groups with the required skills and capacity Research has found a link between good governance and good investment performance Sound governance aims to align asset allocation and its implementation to achieve the asset owner’s stated goals The reading focuses on investment governance structures relevant to the pension plan as these tend to be commonly formalized and articulated in detail 4.1 Governance Structures Governance focuses on clarifying the mission, creating a plan, and reviewing progress towards achieving longand short-term objectives Management, on the other hand, focuses on the execution of the plan to achieve the agreed upon objectives and goals The three levels of a governance hierarchy for an institutional investor include: • • • One the asset portfolio is structured it must be monitored regularly and rebalanced as appropriate Regular reporting of portfolio performance and risk evaluation to the client should be made Fundamentals of Investment Governance Investment governance represents the organization of decision-making responsibilities and oversight activities • FinQuiz.com Governing investing committee: may comprise a subset of the board of directors or an internal committee of staff members Investment staff: staff may comprise of individuals which have full asset management capabilities or a few individuals who are responsible for overseeing external investment managers and consultants Third party resources: refers to a range of required professional services that may not be available in-house such as investment managers, investment consultants and so forth The six common elements of effective governance models are discussed in the sections 4.2 – 4.6 4.2 Articulating Investment Objectives Articulating long- and short-term objectives for an investor requires an understanding of purpose For example, the investment objective statement of a pension plan would be to ensure that plan assets are sufficient to meet current and future pension liabilities A manager needs to understand the following factors when developing the IPS: • • • • client’s return requirement the obligations the assets are required to fund nature of cash flows into and out of the portfolio asset owner’s willingness and ability to withstand interim declines in portfolio value The manager needs to find the best risk/return tradeoff that is consistent with the client’s resource constraints and tolerance for risk Both long- and short-term objectives need to be understood The status of the pension plan (active or frozen) and funded ratio (plan assets/plan liabilities) has a bearing on future contributions and benefit payments A plan sponsor operating in a cyclical industry may prefer conservative asset allocation to minimize volatility of pension contributions The nature of inflows and outflows differs across investor types Endowments have some control over outflows but little control over timing and amount of inflows When determining risk tolerance, multiple risk dimensions should be considered such as liquidity risk, volatility, and the risk of abandoning a course of action at the wrong time Effective governance requires considering the liquidity needs of the fund and liquidity characteristics of the fund High risk/high expected return allocations is likely to lead to wide swings in interim valuations and should be considered in the asset allocation decision Reading 4.3 Overview of the Asset Management Industry and Portfolio Management Allocation of Rights and Responsibilities Rights and responsibilities needed to execute the investment program are decided at the highest governance level Decisions should be delegated to the most qualified individuals to make them Allocation of rights and responsibilities depends on the following factors: • • • 4.4 Investment Policy Statement The investment policy statement (IPS) is the foundation of an effective investment program, serves as the foundation for ongoing fund management and assures stakeholders program assets are managed with care and diligence Features of an IPS: • size of the investment program knowledge, skills and abilities of the internal staff amount of time staff can devote to the investment program especially with competing responsibilities The resources available to an organization will affect the scope and complexity of the investment program and allocation of rights and responsibilities For example: • • • A small asset size for the investment program will make diversification difficult across asset classes and investment managers Complex strategies may not be feasible when an entity: o lacks developed internal investment expertise or o has an oversight committee which lacks individuals with sufficient investment understanding • • • Organization willing to invest in attracting, developing, and retaining staff resources and developing internal controls are better able to adopt complex investment programs For large investors, their size may limit their ability to carry out effective oversight of many investment managers or otherwise create other governance issues When allocating rights and responsibilities across the governance hierarchy, effective governance requires that decision-making should be delegated to those with the required knowledge to thoroughly evaluate alternative courses of action, the capacity to assume ongoing responsibility of these decisions, and the ability to timely execute those decisions Refer to Exhibit 13 of the reading for a systematic way of allocating duties and responsibilities of running the investment program Note: The allocation of rights and responsibilities is influenced by: • • • available knowledge and expertise at each level of the hierarchy, resource capacity of decision makers, and ability to act on a timely basis FinQuiz.com Introduction: describes purpose and scope of the document itself and describes the asset owner The purpose and scope section should provide a link between goals and objectives of the asset owner and execution of the investment program The description of the asset owner should address the: o context in which the investment program exists, o business environment of the asset owner, and the o sources and uses of program assets Investment objectives statement: described the asset owner’s philosophy with respect to pursuing returns and the willingness to endure volatility in achieving these objectives A statement of duties and responsibilities: outlines allocation of decision rights and responsibilities among investment committee, investment staff and third-party service providers Explanation of investment guidelines to be followed and any assets excluded from investments A section specifying frequency and nature of reporting to the investment committee and to the board of directors IPS will also provide direction for the risk management of investment funds The IPS is revised slowly over time but variable aspects of the program such as the asset allocation policy and investment manager guidelines will be contained in a more easily modifiable index 4.5 Asset Allocation and Rebalancing Policy Strategic asset allocation is generally approved by the investment committee Proposals for the strategic asset allocation consider obligations, objectives, and constraints; simulates possible investment outcomes over an agreed upon horizon and evaluates risk and return characteristics of the possible allocation strategies Good governance also considers rebalancing decisions IPS should consider general information relevant to rebalancing Specifying rebalancing responsibilities is good governance Reading 4.6 Overview of the Asset Management Industry and Portfolio Management Reporting Framework The reporting framework should allow individuals to evaluate how quickly and objectively the investment program is progressing towards agreed-upon goals and objectives The reporting should answer the following questions: • • • Where are we now? Where are we relative to goals and objectives? What value has been added? Key elements of a reporting framework should address performance evaluation, compliance with investment guidelines, and progress toward achieving stated goals and objectives • • • 4.7 Benchmarking – necessary for performance measurement, attribution, and evaluation Effective benchmarking allows the investment committee to evaluate staff and external managers Management reporting – indicates which parts of the portfolio are performing ahead of the others and whether assets are managed in accordance with investment guidelines Governance reporting – addresses strengths and weaknesses in program execution through regular committee meetings which can address any concerns The Governance Audit The purpose of the governance audit is to ensure that established policies, procedures, and governance structures are effective Governance audits should be performed by an independent third party The governance auditor: • • • examines the fund’s governing documents, assesses the capacity of the organization to execute effectively within the confines of those documents, and evaluates the existing portfolio for efficiency given the governance constraints Effective investment governance: • • • Ensures the durability of the investment program Avoid decision-reversal risk: the risk of reversing a chosen course of action at the wrong time – the point of maximum loss Considers the effect of investment committee and staff turnover on the durability of the • • FinQuiz.com investment program Prevents key person risk: overreliance on one person or long-term illiquid investments dependent on a staff member Assures responsibility and prevent the avoidance of personal responsibility Practice: Example & 2, CFA Curriculum, Volume 1, Reading  ... institutions or their investment consultants 2 .5. 1) Individual/Retail Investors The largest SWFs are concentrated in Asia and in natural resource-rich countries 2 .5. 2 .3) Banks Banks are financial intermediaries... asset managers Insurers may also manage investments for third-party clients 2 .5. 2.2) Sovereign Wealth Funds (SWFs) 2 .5. 2 .5) Endowments and Foundations SWFs are state-owned investment funds or entities... to convert structured and unstructured data into alpha generating and securitylevel decisions FinQuiz. com • 2.7 .3) Robo-Advisers: An Emerging Wealth Management Channel Growing demand from mass