Investment Management

How well investment risk is managed is a key determinant of the success of investment management.

In investment terms, risk is the possibility that the actual realised return on an investment will be something other than the return originally expected on the investment. Fluctuations in the prices and values of investments??reflect the risk of investing. The trade-off between risk and return is a fundamental issue in investment management.

Typically, the higher the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return.

• Systematic risk: The risk created by general economic conditions is known as systematic or market risk because the risk stems from the wider economic system.
• Specific risk: Risk that is specific to a certain company or security is variously known as specific, idiosyncratic, non-systematic, or unsystematic risk.

The distinction between systematic and specific risk is important because the two types of risk have different implications for investors. More exposure to systematic risk tends to be associated with higher expected returns over the long term. In the process, investors take on specific risk; if they turn out to be correct, they may earn a higher return as a result of taking on more risk.

When assets and/ or asset classes with different characteristics are combined in a portfolio, the overall level of risk is typically reduced. Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets.

Overall, this means the risk return trade-off, which is a key concern for investors, is better for a portfolio of assets than for individual assets. Adding more securities to a portfolio will reduce risk through diversification, although eventually the additional benefits begin to lessen. For example, an investor might combine investments in various stock and bond markets with investments in real estate and commodities to reduce the overall risk of a portfolio.

After developing the investment policy statement?, which includes among other information an investor's willingness and ability to take risk, the asset allocation of the portfolio is determined. In some cases, the asset allocation decision is documented as part of the IPS; in other cases, asset allocation is regarded as part of the subsequent implementation of the IPS.

Strategic asset allocation is the long-term mix of assets that is expected to meet the investor's objectives. The desired overall risk and return profile of the portfolio is a factor in determining the strategic asset allocation. A portfolio with a strategic asset allocation dominated by equities would be expected to have a higher return and be more volatile than a portfolio dominated by, say, bonds because bonds generally have lower risk than equities and thus produce lower returns.

Strategic asset allocation typically requires investment managers to estimate the expected risk and return of each asset class. The chosen strategic asset allocation is expected to meet the investor's long-term risk and return objectives.

An investor may set the strategic asset allocation and simply hold a portfolio for the life of the investment. Tactical Asset Allocation Although the chosen strategic asset allocation is expected to meet the investor's objectives over the long term, there are times when shorter-term fluctuations in asset class returns can be exploited to potentially increase portfolio returns.

A short-term adjustment among asset classes is known as tactical asset allocation.an investor has a strategic asset allocation of 60% global equities and 40% European government bonds. In response, the manager could adjust the asset allocation to 50% equities and 50% bonds. If the manager's expectation is correct, this 50/50 tactical allocation will perform better in the short term than the strategic asset allocation of 60/40.

The difficulty of financial forecasting means investors may choose to maintain their strategic asset allocation within predetermined ranges. Such ranges allow for some tactical asset allocation and reduce the need for and expense of frequent portfolio rebalancing. Tactical asset allocation represents an attempt to add value to a portfolio by deviating from the strategic asset allocation.

Active managers attempt to add value to a portfolio by selecting investments that are expected, on the basis of analysis, to outperform a specified benchmark. The choice between the two approaches typically hinges on the relative costs of active management compared with passive management and on the investor's expectation of the success of active management.

The expectation is related to the investor's beliefs about the efficiency of the markets being invested in. An investor may decide to use a passive approach in some markets and an active approach in other markets based on an assessment of the efficiency of each market.

an informationally efficient market is one in which the prices of investments reflect available information about the fundamental values and return prospects of the assets they represent. They argue that public information flows may not be as extensive or reliable in emerging economies and that it is possible for some investors to access and use information that is not available to others. For instance, information on these investments may not be publicly available and trading is less active and done privately rather than in a public market in which prices and volumes can be observed.

In cases where inefficiency is believed to exist, it is reasonable to believe that active management may be a successful approach.

Passive investment managers seek to match the return and risk of a benchmark. Passive investment managers attempt to minimise tracking error.the tracking error is the deviation of the return on the portfolio from the return on the benchmark being tracked. Passive managers may try to fully replicate the benchmark by holding all the securities in the benchmark in proportions equivalent to their weighting in the benchmark.

So, instead of full replication, passive managers may use a tracking approach and hold a subset of the market that is expected to closely track the benchmark's returns and risk.

For example, a passive manager in the UK equity market has the choice of replicating the FTSE 100 market index directly or attempting to track the index by selecting a subset of shares to represent each industrial sector of the market. Whatever passive investment approach is used, a passive investor must be willing to accept the risk of the underlying market.

Active managers may also try to time a market (buying when they believe the market is undervalued and selling when they believe the market is overvalued). For active managers to be consistently successful, they have to be better than other investors at assessing the potential of investments. For active managers to identify outperforming securities on a consistent basis, they must either have access to better information than other investors or be able to respond and use the same information faster or with better models to process the information. Also, for active management to be successful, any mispricing of investments has to be substantial enough to cover the costs of exploiting this mispricing.

But the choice between passive and active management is a key issue for investors and the decision must be weighed carefully. If active management does achieve returns that are higher than the benchmark, the excess return may compensate for the higher employee, technology, and transaction costs and the net returns to the investor may be higher.

Other managers use technical and behavioural models to identify trends and momentum in the market and to predict how trading by other market participants may change future market prices.

Some active managers build statistical or quantitative models to try to identify shares that are likely to outperform or underperform. In practice, many managers use a blend of the techniques Based on their analysis, active managers purchase assets that are expected to have superior returns and sell assets that are expected to underperform.

Fundamental Analysis Active managers often try to identify and capture market inefficiencies through fundamental analysis. If the share price is significantly below the estimated value, the manager will increase the weighting of the shares in the portfolio or add the shares to the portfolio.

the value of a security can be viewed as the present value of all the cash flows the security will generate in the future. For example, investors can estimate the value of a stock by discounting all the dividends they expect to receive while they hold the stock and adding the proceeds from selling the stock. Managers using fundamental analysis operate on the premise that security market prices tend to move toward their estimates of fundamental values. The issues most important to their opinions vary according to the type of asset they are analysing.

Lenders consider borrowers to be creditworthy if they expect that the borrowers will be able to pay interest, principal, and preferred dividends when due. They consider borrowers to be trustworthy if they expect that borrowers will arrange their affairs to ensure that they can and will make these payments.

For example, when analysing real estate investments, managers consider how the value of the property compares with similar properties in the area, how its rental prospects might develop in the future, and whether there is scope to add value to the property through redevelopment.

Managers using fundamental analysis consider the specific factors that are expected to affect the value of the type of asset being analysed. Some investment managers use a technical approach, seeking to assess price and trading volume trends in the stock market to identify shares that may outperform or underperform. For example, an active manager who believes in momentum will try to invest in shares that have recently been rising in the market, which is based on the notion that a rising share will continue to rise.

Other managers might look for signs of imbalance between the potential buyers and sellers of a share to try to predict which direction the share is likely to move.an increase in demand or a decrease in supply will typically cause prices to increase.

Investment managers who use technical and behavioural approaches try to buy a particular security or asset before an increase in buyer interest or a decrease in seller interest causes the price of the security to rise, and they try to sell before an increase in seller interest or a decrease in buyer interest causes the price of the security to fall.

Quantitative Analysis Some managers build statistical models to try to identify shares that are likely to outperform. For example, the analysis might suggest that companies with below-market average valuation levels (for example, the ratio of the share price to earnings per share, known as P/E) and above-average expected earnings growth tend to outperform. Managers using this approach are often called "quants", because of the quantitative models they use.

Slahdji Mohamed Oussalem