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Student Publications
Author: Richard Adams
Title:
Investment Management
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Investment management is the professional management of various
securities (shares,
bonds etc) assets
(e.g. real estate), to meet specified investment goals for the
benefit of
the investors. Investors may be institutions (insurance companies,
pension funds,
corporations etc.) or private investors (both directly via
investment contracts and more
commonly via collective investment schemes e.g. mutual funds) .
The term asset management is often used to refer to the
investment management of
collective investments, whilst the more generic fund management
may refer to all forms
of institutional investment as well as investment management for
private investors.
Investment managers who specialize in advisory or
discretionary management on behalf
of (normally wealthy) private investors may often refer to their
services as wealth
management or portfolio management often within the
context of so-called "private
banking".
The provision of 'investment management services' includes elements
of financial
analysis, asset selection, stock selection, plan implementation and
ongoing monitoring of
investments. Investment management is a large and important global
industry in its own
right responsible for caretaking of trillions of dollars, euro,
pounds and yen. Coming
under the remit of financial services many of the world's largest
companies are at least in
part investment managers and employ millions of staff and
create billions in revenue.
Fund manager (or investment advisor in the U.S.)
refers to both a firm that provides
investment management services and an individual(s) who directs
'fund management'
decisions.
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Industry scope
The business of investment management has several facets, including
the employment of
professional fund managers, research (of individual assets and asset
classes), dealing,
settlement, marketing, internal auditing, and the preparation of
reports for clients. The
largest financial fund managers are firms that exhibit all the
complexity their size
demands. Apart from the people who bring in the money (marketers)
and the people who
direct investment (the fund managers), there are compliance staff
(to ensure accord with
legislative and regulatory constraints), internal auditors of
various kinds (to examine
internal systems and controls), financial controllers (to account
for the institutions' own
money and costs), computer experts, and "back office" employees (to
track and record
transactions and fund valuations for up to thousands of clients per
institution).
Key problems of running such businesses
Key problems include:
revenue is directly linked to market valuations, so a major fall in
asset prices
causes a precipitous decline in revenues relative to costs;
above-average fund performance is difficult to sustain, and clients
may not be
patient during times of poor performance;
successful fund managers are expensive and may be headhunted by
competitors;
above-average fund performance appears to be dependent on the unique
skills of
the fund manager; however, clients are loath to stake their
investments on the
ability of a few individuals- they would rather see firm-wide
success, attributable
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to a single philosophy and internal discipline;
Evidence suggests that size of an investment firm correlates
inversely with fund
performance, i.e., the smaller the firm the better the chance of
good performance.
Analysts who generate above-average returns often become
sufficiently wealthy
that they eschew corporate employment in favor of managing their
personal
portfolios.
The most successful investment firms in the world have probably been
those that have
been separated physically and psychologically from banks and
insurance companies. That
is, the best performance and also the most dynamic business
strategies (in this field) have
generally come from independent investment management firms.
Representing the owners of shares
Institutions often control huge shareholdings. In most cases they
are acting as agents
(intermediaries between owners of the shares and the companies
owned) rather than
principals (direct owners). The owners of shares theoretically have
great power to alter
the companies they own...via the voting rights the shares carry and
the consequent ability
to pressure managements, and if necessary out-vote them at annual
and other meetings.
In practice, the ultimate owners of shares often do not exercise the
power they
collectively hold (because the owners are many, each with small
holdings); financial
institutions (as agents) sometimes do. There is a general belief
that shareholders - in this
case, the institutions acting as agents--could and should exercise
more active influence
over the companies in which they hold shares (e.g., to hold managers
to account, to
ensure Boards effective functioning). Such action would add a
pressure group to those
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(the regulators and the Board) overseeing management.
However there is the problem of how the institution should exercise
this power. One way
is for the institution to decide, the other is for the institution
to poll its beneficiaries.
Assuming that the institution polls should it then vote the entire
holding as directed by
the majority of votes cast, split vote (where this is allowed)
according to the proportions
of the vote or respect the abstainers and only vote the respondents
holding.
The price signals generated by large active managers holding or not
holding the stock
contribute to management change.
Some institutions have been more vocal and active in pursuing such
matters; for instance,
some firms believe that there are investment advantages to
accumulating substantial
minority shareholdings (i.e, 10% or more) and putting pressure on
management to
implement significant changes in the business. In some cases,
institutions with minority
holdings work together to force management change. Perhaps more
frequent is the
sustained pressure that large institutions bring to bear on
management teams through
persuasive discourse and PR. On the other hand, some of the largest
investment
managers--such as Barclays Global Investors and Vanguard--advocate
simply owning
every company, reducing the incentive to influence management teams.
The national context in which shareholder representation
considerations are set is
variable and important. The USA is a litigious society and
shareholders use the law as a
lever to pressure management teams. In Japan it is traditional for
shareholders to be low
in the 'pecking order,' which often allows management and labor to
ignore the rights of
the ultimate owners. Whereas US firms generally cater to
shareholders, Japanese
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businesses generally exhibit a stakeholder mentality, in which
they seek consensus
amongst all interested parties (against a background of strong
unions and labour
legislation).
Size of the global fund management industry
Assets of the global fund management industry increased for the
third year running in
2006 to reach a record $55.0 trillion. This was up 10% on the
previous year and 54% on
2002. Growth during the past three years has been due to an increase
in capital inflows
and strong performance of equity markets.
Pension assets totalled $20.6 trillion in 2005, with a further $16.6
trillion invested in
insurance funds and $17.8 trillion in mutual funds. Merrill Lynch
also estimates the value
of private wealth at $33.3 trillion of which about a third was
incorporated in other forms
of conventional investment management.
The US was by far the largest source of funds under management in
2005 with 48% of
the world total. It was followed by Japan with 11% and the UK with
7%. The Asia-
Pacific region has shown the strongest growth in recent years.
Countries such as China
and India offer huge potential and many companies are showing an
increased focus in
this region.
Philosophy, process and people
The 3-P's (Philosophy, Process and People) are often used to
describe the reasons why
the manager is able to produce above average results.
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Philosophy refers to the over-arching beliefs of the investment
organization. For
example, does the manager buy growth or value shares (and why), does
he believe
in market timing (and on what evidence), does he rely on external
research or
does he employ a team of researchers. It is helpful if any and all
of such
fundamental beliefs are supported by proof-statements.
Process refers to the way in which the overall philosophy is
implemented. For
example, which universe of assets is explored before particular
assets are chosen
as suitable investments; how does the manager decide what to buy and
when; how
does the manager decide what to sell and when; who takes the
decisions and are
they taken by committee; what controls are in place to ensure that a
rogue fund
(one very different from others and from what is intended) cannot
arise;
People refer to the staff, especially the fund managers. The
question is who are
they, how are they selected, how old are they, who reports to whom,
how deep is
the team (and do all the members understand the philosophy and
process they are
supposed to be using), and most important of all how long has the
team been
working together. This last question is vital because whatever
performance record
was presented at the outset of the relationship with the client may
or may not
relate to (have been produced by) a team that is still in place. If
the team has
changed greatly (high staff turnover), then arguably the performance
record is
completely unrelated to the existing team (of fund managers).
Investment managers and portfolio structures
At the heart of the investment management industry are the managers
who invest and
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divest client investments.
A certified company investment advisor should conduct an assessment
of each client's
individual needs and risk profile. The advisor then recommends
appropriate investments.
Asset allocation
The different asset classes are stocks, bonds, real-estate and
commodities. The exercise of
allocating funds among these assets (and among individual securities
within each asset
class) is what investment management firms are paid for. Asset
classes exhibit different
market dynamics, and different interaction effects; thus, the
allocation of monies among
asset classes will have a significant effect on the performance of
the fund. Some research
suggests that allocation among asset classes has more predictive
power than the choice of
individual holdings in determining portfolio return. Arguably, the
skill of a successful
investment manager resides in constructing the asset allocation, and
separately the
individual holdings, so as to outperform certain benchmarks (e.g.,
the peer group of
competing funds, bond and stock indices).
Long-term returns
It is important to look at the evidence on the long-term returns to
different assets, and to
holding period returns (the returns that accrue on average over
different lengths of
investment). For example, over very long holding periods (eg. 10+
years) in most
countries, equities have generated higher returns than bonds, and
bonds have generated
higher returns than cash. According to financial theory, this is
because equities are riskier
(more volatile) than bonds which are, more risky than cash.
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Diversification
Against the background of the asset allocation, fund managers
consider the degree of
diversification that makes sense for a given client (given its risk
preferences) and
construct a list of planned holdings accordingly. The list will
indicate what percentage of
the fund should be invested in each particular stock or bond. The
theory of portfolio
diversification was originated by Markowitz and effective
diversification requires
management of the correlation between the asset returns and the
liability returns, issues
internal to the portfolio (individual holdings volatility), and
cross-correlations between
the returns.
Investment styles
There are a range of different styles of fund management that the
institution can
implement. For example, growth, value, market neutral, small
capitalization, indexed, etc.
Each of these approaches has its distinctive features, adherents
and, in any particular
financial environment, distinctive risk characteristics. For
example, there is evidence that
growth styles (buying rapidly growing earnings) are especially
effective when the
companies able to generate such growth are scarce; conversely, when
such growth is
plentiful, then there is evidence that value styles tend to
outperform the indices
particularly successfully.
Performance measurement
Fund performance is the acid test of fund management, and in the
institutional context
accurate measurement is a necessity. For that purpose, institutions
measure the
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performance of each fund (and usually for internal purposes components
of each fund)
under their management, and performance is also measured by external
firms that
specialize in performance measurement. The leading performance
measurement firms
(e.g. Frank Russell in the USA) compile aggregate industry data e.g
showing how funds
in general performed against given indices and peer groups over
various time periods.
In a typical case (let us say an equity fund), then the calculation
would be made (as far as
the client is concerned) every quarter and would show a percentage
change compared
with the prior quarter (e.g. +4.6% total return in US dollars). This
figure would be
compared with other similar funds managed within the institution
(for purposes of
monitoring internal controls), with performance data for peer group
funds, and with
relevant indices (where available) or tailor-made performance
benchmarks where
appropriate. The specialist performance measurement firms calculate
quartile and decile
data and close attention would be paid to the (percentile) ranking
of any fund.
Generally speaking it is probably appropriate for an investment firm
to persuade its
clients to assess performance over longer periods (e.g. 3 to 5
years) to smooth out very
short term fluctuations in performance and the influence of the
business cycle. This can
be difficult however and, industrywide, there is a serious
pre-occupation with short-term
numbers and the effect on the relationship with clients (and
resultant business risks for
the institutions).
An enduring problem is whether to measure before-tax or after-tax
performance. After-
tax represents the benefit to the investor, but investors tax
positions vary. Before tax
measurement can mislead, especially in regimens that tax realised
capital gains (and not
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unrealised). A successful active manager, measured before tax, can
thus produce a
miserable after tax result. One possible solution is to report the
after-tax position of some
standard tax-payer.
Absolute versus relative performance
In the USA and the UK, two of the world's most sophisticated fund
management markets,
the tradition is for institutions to manage client money relative to
benchmarks. For
example, an institution believes it has done well if it has
generated a return of 5% when
the average manager generates a 4% return.
Risk-adjusted performance measurement
Performance measurement should not be reduced to the evaluation of
fund returns alone,
but must also integrate other fund elements that would be of
interest to investors, such as
the measure of risk taken. Several other aspects are also part of
performance
measurement: evaluating if managers have succeeded in reaching their
objective, i.e. if
their return was sufficiently high to reward the risks taken; how
they compare to their
peers; and finally whether the portfolio management results were due
to luck or the
manager's skill. The need to answer all these questions has led to
the development of
more sophisticated performance measures, many of which originate in
modern portfolio
theory.
Modern portfolio theory established the quantitative link that
exists between portfolio
risk and return. The Capital Asset Pricing Model (CAPM) developed by
Sharpe (1964)
highlighted the notion of rewarding risk and produced the first
performance indicators, be
they risk-adjusted ratios (Sharpe ratio, information ratio) or
differential returns compared
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to benchmarks (alphas). The Sharpe ratio is the simplest and best
known performance
measure. It measures the return of a portfolio in excess of the
risk-free rate, compared to
the total risk of the portfolio. This measure is said to be
absolute, as it does not refer to
any benchmark, avoiding drawbacks related to a poor choice of
benchmark. Meanwhile,
it does not allow the separation of the performance of the market in
which the portfolio is
invested from that of the manager. The information ratio is a more
general form of the
Sharpe ratio in which the risk-free asset is replaced by a benchmark
portfolio. This
measure is relative, as it evaluates portfolio performance in
reference to a benchmark,
making the result strongly dependent on this benchmark choice.
Portfolio alpha is obtained by measuring the difference between the
return of the
portfolio and that of a benchmark portfolio. This measure appears to
be the only reliable
performance measure to evaluate active management. In fact, we have
to distinguish
between normal returns, provided by the fair reward for portfolio
exposure to different
risks, and obtained through passive management, from abnormal
performance (or
outperformance) due to the manager's skill, whether through market
timing or stock
picking. The first component is related to allocation and style
investment choices, which
may not be under the sole control of the manager, and depends on the
economic context,
while the second component is an evaluation of the success of the
manager's decisions.
Only the latter, measured by alpha, allows the evaluation of the
manager's true
performance.
Portfolio normal return may be evaluated using factor models. The
first model, proposed
by Jensen (1968), relies on the CAPM and explains portfolio normal
returns with the
market index as the only factor. It quickly becomes clear, however,
that one factor is not
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enough to explain the returns and that other factors have to be
considered. Multi-factor
models were developed as an alternative to the CAPM, allowing a
better description of
portfolio risks and an accurate evaluation of managers' performance.
For example, Fama
and French (1993) have highlighted two important factors that
characterise a company's
risk in addition to market risk. These factors are the
book-to-market ratio and the
company's size as measured by its market capitalisation. Fama and
French therefore
proposed a three-factor model to describe portfolio normal returns.
Carhart (1997)
proposed to add momentum as a fourth factor to allow the persistence
of the returns to be
taken into account. Also of interest for performance measurement is
Sharpe's (1992)
style analysis model, in which factors are style indices. This model
allows a custom
benchmark for each portfolio to be developed, using the linear
combination of style
indices that best replicate portfolio style allocation, and leads to
an accurate evaluation of
portfolio alpha.
Education or Certification
Increasingly, international business schools are incorporating the
subject into their course
outlines and some have formulated the title of 'Investment
Management' conferred as
specialist bachelors degrees. (i.e. Cass Business School, London).
Due to global cross-
recognition agreements with the 2 major accrediting agencies AACSB
and ACBSP which
accredit over 560 of the best business school programs, the
Certification of MFP Master
Financial Planner Professional from the American Academy of
Financial Management is
available to AACSB and ACBSP business school graduates with finance
or financial
services related concentrations. For people with aspirations to
become an investment
13
manager, further education may be needed beyond a B.S. in business,
finance, or
economics. A graduate degree or an investment certification such as
Chartered Financial
Analyst (CFA) or Chartered Alternative Investment Analyst (CAIA) may
be required to
move up in the ranks of investment management
References
(2006-08-01).
"Fund Management: City Business Series"
(PDF). International Financial
Services, London. Retrieved on 2007-02-01.
David Swensen, "Pioneering Portfolio
Management: An Unconventional Approach to Institutional Investment,"
New York, NY:
The Free Press, May 2000.
Rex A. Sinquefeld and Roger G. Ibbotson, Annual Yearbooks dealing
with Stocks,
Bonds, Bills and Inflation (relevant to long term returns to US
financial assets).
Harry Markowitz, Portfolio Selection: Efficient Diversification of
Investments, New
Haven: Yale University Press
S.N. Levine, The Investment Managers Handbook, Irwin Professional
Publishing (May
1980), ISBN 0-87094-207-7.
V. Le Sourd, 2007, Performance Measurement for Traditional
Investment � Literature
Survey, EDHEC Publication.
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