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Investment - Factors that Affect Investors' Needs
Investors — whether individual or institutional — have distinct investment objectives. Key factors that are universal to all investors, but that will vary in amplitude for each investor, include the following:
Required return
Risk tolerance
Time horizon
Investors may also have distinct needs in relation to liquidity, tax concerns, regulatory necessity, compatibility with particular religious or ethical standards, or other unique conditions. Investors’ situations and needs change over time, therefore it is vital to re-evaluate their needs at least annually.
Required Return
Investors differ in how much return they need to accomplish their aims. The rate of return required, before and after tax, can be estimated using some aim for future wealth or portfolio value.
For example, depending on an investor’s age, initial investable assets, planned savings, and tax situation, an adviser may calculate that a 6% rate of return before tax on investments is required for the investor to reach his or her goal of having a EUR500,000 portfolio value at retirement.
If the desired rate of return seems unlikely to be obtained, the investor’s goals may have to be updated or other criteria, such as the quantity of savings, may have to be adjusted.
An investor may use a total-return perspective, which sees no distinction between income (for example, dividends and interest) and capital gains (i.e., rises in market value). The source of return — changes in value or income — does not matter to a total-return-oriented investor. Alternatively, an investor may discriminate between income and capital gains, seeking income for present consumption and capital gains for long-term requirements.
The return criterion, particularly for a long-term horizon, should be defined in real terms, which involves compensating for the effect of inflation. This modification is vital because it preserves the emphasis on what the accumulating portfolio will give at the conclusion of the time horizon. An increase in value that simply equals inflation does not give a client more spending power.
The investment manager or adviser has to be comfortable that the investor’s targeted rate of return is possible within the related limits. Most clients would desire high returns with little risks, but few investments offer this expected profile. The adviser or manager has a role in counselling the customer.
Typically, higher levels of expected return will require higher amounts of risk to be taken.
Some investors will prefer to invest in hazardous assets because they require high levels of return to fulfill their goals, but the potential implications (the negative risks) connected with this strategy need to be addressed.
Other investors will have previously collected sufficient assets that they do not require significant returns to fulfill their goals and can choose a lower-risk approach. This condition could be the case for a pension plan that has a high funding level, indicating that its assets are adequate, or almost sufficient, to satisfy its liabilities.
Other individuals that have gathered considerable assets may choose to invest in riskier assets since they are capable of absorbing the risk and are able to fulfill their goals even if they experience losses.
Investors, particularly individual investors, will frequently modify the proportion they invest in different kinds of assets over time as they age and their circumstances change. Individual investors with defined contribution pension plans can also alter their investments inside the defined contribution plan.
Risk Tolerance
Investors often have restrictions on how much risk they are willing and able to take with their investments. As discussed earlier, there is a connection between risk and return. Typically, the bigger the predicted return, the higher the risk connected with that return. Equally, the more risk taken, the bigger the projected reward. The investor’s risk tolerance is a result of their ability and willingness to take risk.
g
The ability to assume risk relies on the condition of the investor, such as the balance between assets and obligations and the time horizon. If individual investors have significantly more assets than liabilities, any losses that occur from risk taking may not impact their lifestyle. If investors have a lengthy time horizon, they have more freedom to adapt their circumstances to cope with losses by saving more or waiting for markets to rebound, although recovery and its timing cannot be assured.
Willingness to take risk is tied to the investor’s psychology, which may be examined using questionnaires. desire to take risk is frequently considered of as a more relevant issue for individual investors, but even those who oversee institutional investments will have risk guidelines within which they must work and that help define their ability and desire to take risk.
" "
Some institutional investors, such as insurance companies and other financial intermediaries, may also face regulatory constraints on how much risk they can take with their holdings.
There may be scenarios in which an individual investor’s willingness to accept risk and their ability to take risk diverge. In such cases, the investment adviser should counsel the investor on risk and assess the right level of risk to take in the portfolio, taking into account both the investor’s ability and willingness to take risk. The lowest of the two risk levels should be the risk level adopted.
Time Horizon
The investor and adviser must be clear on the time horizon for the investments. Some investors will need to access money from their portfolios in the immediate term, but others will have a much longer time horizon.
" "
On the institutional side, for example, a property and casualty insurance company that expects to have to meet claims in the next few years will have a short time horizon, whereas a sovereign wealth fund that is investing oil revenues for the benefit of future generations will have a long time horizon, possibly decades.
Someone who is intending on buying new house, new automobile or paying for education in two or three years would have a short horizon which is a fraction of his investment.
A 20 years old investing for retirement will have a lengthy horizon and mehr than 40 years.
The investment horizon has crucial consequences for how much risk can be taken with the portfolio and the level of liquidity that may be necessary. Liquidity is the ease with which the investment can be converted into cash. For example, an illiquid private equity investment with an anticipated payout in 10 years would be unsuitable for an investor with a 5-year investment horizon.
Both institutions and people must also consider longevity risk, which refers to the potential that life expectancy surpasses expectations and resulting in greater-than-expected cash flow needs in the future.
INDIVIDUAL LONGEVITY RISK
Individuals planning for retirement face the risk of outliving their assets.
INSTITUTIONAL LONGEVITY RISK
Institutions, such as pension funds and insurance firms, are exposed to high longevity risk when guaranteeing guaranteed lifetime payments. As medicine develops and wealth levels rise, longevity risks will increase and induce more adoption of risk mitigation techniques (e.g., expenditure modifications, insurance risk pooling) among individuals and institutions
Investors with longer time horizons should be able to assume greater risk since they have more time to adapt to their circumstances. For example, they can save extra to compensate for any losses or returns that are less than projected.
History shows that, over time, markets go up more often than they go down, thus an investor with a longer time horizon has greater chance to build good return performance.
Longer-term investors are also better equipped to wait for markets to rebound from a period of bad performance, but recovery cannot be guaranteed.
Liquidity
Investors vary in the amount to which they may need to remove money from their holdings. They may need to make a withdrawal to fund a specific purchase or to build a monthly revenue stream. These needs have ramifications for the types of investments chosen. When liquidity is required, the investments will need to be convertible to cash relatively fast and without too much expense (keeping transaction costs and variations in price low) when the cash is needed.
Individual Investors
An person may require that a portion of the portfolio be liquid to pay unanticipated needs. In addition, the individual may have known future liquidity requirements, such as an anticipated future expenditure on children’s schooling or retirement income demands.
Institutional Investors
For an institution, the liquidity restriction often reflects the institution’s liabilities. For example, a pension fund may expect to begin suffering net cash withdrawals at a given time in the future (i.e., when pension payments exceed new contributions to the plan) and will need to sell off some portfolio investments to fulfill those demands. It needs to hold liquid assets in order to do this.
Regulatory Issues
Some sorts of investors have regulatory restrictions that apply to their investments.
For example, in some countries and for certain types of institutional investors, there are restrictions on the proportion of the portfolio that can be invested overseas or in riskier assets, such as shares. Regulations on the holdings of insurance companies are often substantial to protect policy holders.
Taxes
The tax situations of investors differ. Some categories of investors are taxed on their investment returns, and others are not. For example, in many nations, pension funds are excluded from tax on investment returns. Furthermore, the tax treatment of income and capital gains can differ. It is crucial for investment advisers to evaluate an investor’s tax situation and the tax repercussions of alternative investments.
Investors should care about the profits they make after taxes and fees since that is what is available to spend. For example, an investor who is subject to higher tax on dividend income than capital gains will normally choose a portfolio of assets targeting capital growth (i.e., from an increase in value of shares) rather than income (i.e., dividends from shares).
Individuals may also face various tax circumstances for different components of their wealth.
For example, an individual may opt to maintain some assets in a pension account if income and capital gains on assets held in a pension account are tax-exempt or tax-deferred. The investor may choose to hold assets expected to generate capital gains in a taxable investment account if capital gains are taxed at a lower rate than income. Where assets are held can considerably affect an investor’s after-tax profits and wealth building.
Unique Circumstances
Many investors have special requirements or limits not reflected by the traditional categories addressed thus far.
Some investors evaluate how environmental, social, and governance concerns (together known as ESG investing) impact the financial performance of possible investments. Beyond assessing ESG risks associated with an investment, some investors expressly pursue an impact investing approach, which targets investments having beneficial and measurable societal or environmental outcomes (e.g., using social or environmental measures).
Some other investors directly incorporate religious or ethical preferences and exclusions into their investment preferences. For example, some investors may not participate in traditional debt securities because they do not believe they accord with Islamic law.
Investors may also have special requirements that come from the type of their broader investment portfolio or financial circumstances. For example, an individual who is employed by a corporation may seek to limit investment in that company. Limiting investment in securities issued by their workplace would help the employee reduce single-company risk and acquire broader diversification.
Interestingly, many individuals are actually tempted to expand their holdings in their employers’ shares on the grounds of loyalty or familiarity, despite the danger that this strategy carries. Such a strategy can have significant ramifications if the company fails or its financial position falls. For example, many employees of Enron Corporation, a US energy corporation, not only lost their employment but also suffered huge investment losses when Enron went bankrupt.
Institutional investors may also have unique and specific criteria as a result of their objectives and circumstances. For example, a medical foundation may desire to avoid investing in tobacco stocks because it considers encouraging tobacco smoking is antithetical to its objectives of improving health.
Behavioural Finance Considerations
Behavioural finance aims to understand and explain actual investor behaviour, in contrast to theorising about investor behaviour. It varies from traditional (or standard) finance, which is founded on assumptions of how investors and markets should behave. Behavioural finance is about understanding how individuals make decisions, both individually and collectively.
By understanding how investors and markets behave, it may be able to adjust or adapt to these behaviours in order to enhance investment outcomes. In other words, the way investors think and feel affects the way they behave while making investing decisions. Some of these actions are implicitly impacted by prior experiences and personal beliefs to the extent that even competent investors can break from logic and reason.
These factors, which can be classified and characterized as behavioural biases, can alter the way risk is seen and how risk is understood by someone trying to determine a person’s risk tolerance.
Examples of behavioral biases that effect investment decision making vary by individual and institution and are often classed as either emotional or cognitive biases.
EMOTIONAL BIAS
Emotional biases come from instinct or intuition and tend to result from reasoning impacted by feelings.
Example: Loss Aversion Bias
Investors tend to feel the agony of losses more than the pleasure of wins compared with other client categories. Thus, these investors may hold on to failing investments too long, even when they see little hope of a recovery.
COGNITIVE BIAS
Cognitive biases come from basic statistical, information-processing, or memory problems; cognitive errors often result from erroneous reasoning.
Example: Hindsight Bias
Some investors may be prone to hindsight bias, which happens when an investor interprets prior investment outcomes as if they had been predicted. Investment outcomes are rarely, if ever, predicted.
An example of hindsight bias is the response by investors to the financial crisis of 2008. Initially, many saw the housing market’s performance from 2003 to 2007 as ‘normal’ (i.e., not suggestive of a bubble). It was only later that many said, ‘was it not obvious?’ when the market experienced a catastrophe in 2008. Hindsight bias offers investors a false sense of security when making investing decisions, emboldening them to assume excessive risk without perceiving it as such.
Investors — whether individual or institutional — have distinct investment objectives. Key factors that are universal to all investors, but that will vary in amplitude for each investor, include the following:
Required return
Risk tolerance
Time horizon
Investors may also have distinct needs in relation to liquidity, tax concerns, regulatory necessity, compatibility with particular religious or ethical standards, or other unique conditions. Investors’ situations and needs change over time, therefore it is vital to re-evaluate their needs at least annually.
Required Return
Investors differ in how much return they need to accomplish their aims. The rate of return required, before and after tax, can be estimated using some aim for future wealth or portfolio value.
For example, depending on an investor’s age, initial investable assets, planned savings, and tax situation, an adviser may calculate that a 6% rate of return before tax on investments is required for the investor to reach his or her goal of having a EUR500,000 portfolio value at retirement.
If the desired rate of return seems unlikely to be obtained, the investor’s goals may have to be updated or other criteria, such as the quantity of savings, may have to be adjusted.
An investor may use a total-return perspective, which sees no distinction between income (for example, dividends and interest) and capital gains (i.e., rises in market value). The source of return — changes in value or income — does not matter to a total-return-oriented investor. Alternatively, an investor may discriminate between income and capital gains, seeking income for present consumption and capital gains for long-term requirements.
The return criterion, particularly for a long-term horizon, should be defined in real terms, which involves compensating for the effect of inflation. This modification is vital because it preserves the emphasis on what the accumulating portfolio will give at the conclusion of the time horizon. An increase in value that simply equals inflation does not give a client more spending power.
The investment manager or adviser has to be comfortable that the investor’s targeted rate of return is possible within the related limits. Most clients would desire high returns with little risks, but few investments offer this expected profile. The adviser or manager has a role in counselling the customer.
Typically, higher levels of expected return will require higher amounts of risk to be taken.
Some investors will prefer to invest in hazardous assets because they require high levels of return to fulfill their goals, but the potential implications (the negative risks) connected with this strategy need to be addressed.
Other investors will have previously collected sufficient assets that they do not require significant returns to fulfill their goals and can choose a lower-risk approach. This condition could be the case for a pension plan that has a high funding level, indicating that its assets are adequate, or almost sufficient, to satisfy its liabilities.
Other individuals that have gathered considerable assets may choose to invest in riskier assets since they are capable of absorbing the risk and are able to fulfill their goals even if they experience losses.
Investors, particularly individual investors, will frequently modify the proportion they invest in different kinds of assets over time as they age and their circumstances change. Individual investors with defined contribution pension plans can also alter their investments inside the defined contribution plan.
Risk Tolerance
Investors often have restrictions on how much risk they are willing and able to take with their investments. As discussed earlier, there is a connection between risk and return. Typically, the bigger the predicted return, the higher the risk connected with that return. Equally, the more risk taken, the bigger the projected reward. The investor’s risk tolerance is a result of their ability and willingness to take risk.
g
The ability to assume risk relies on the condition of the investor, such as the balance between assets and obligations and the time horizon. If individual investors have significantly more assets than liabilities, any losses that occur from risk taking may not impact their lifestyle. If investors have a lengthy time horizon, they have more freedom to adapt their circumstances to cope with losses by saving more or waiting for markets to rebound, although recovery and its timing cannot be assured.
Willingness to take risk is tied to the investor’s psychology, which may be examined using questionnaires. desire to take risk is frequently considered of as a more relevant issue for individual investors, but even those who oversee institutional investments will have risk guidelines within which they must work and that help define their ability and desire to take risk.
" "
Some institutional investors, such as insurance companies and other financial intermediaries, may also face regulatory constraints on how much risk they can take with their holdings.
There may be scenarios in which an individual investor’s willingness to accept risk and their ability to take risk diverge. In such cases, the investment adviser should counsel the investor on risk and assess the right level of risk to take in the portfolio, taking into account both the investor’s ability and willingness to take risk. The lowest of the two risk levels should be the risk level adopted.
Time Horizon
The investor and adviser must be clear on the time horizon for the investments. Some investors will need to access money from their portfolios in the immediate term, but others will have a much longer time horizon.
" "
On the institutional side, for example, a property and casualty insurance company that expects to have to meet claims in the next few years will have a short time horizon, whereas a sovereign wealth fund that is investing oil revenues for the benefit of future generations will have a long time horizon, possibly decades.
Someone who is intending on buying new house, new automobile or paying for education in two or three years would have a short horizon which is a fraction of his investment.
A 20 years old investing for retirement will have a lengthy horizon and mehr than 40 years.
The investment horizon has crucial consequences for how much risk can be taken with the portfolio and the level of liquidity that may be necessary. Liquidity is the ease with which the investment can be converted into cash. For example, an illiquid private equity investment with an anticipated payout in 10 years would be unsuitable for an investor with a 5-year investment horizon.
Both institutions and people must also consider longevity risk, which refers to the potential that life expectancy surpasses expectations and resulting in greater-than-expected cash flow needs in the future.
INDIVIDUAL LONGEVITY RISK
Individuals planning for retirement face the risk of outliving their assets.
INSTITUTIONAL LONGEVITY RISK
Institutions, such as pension funds and insurance firms, are exposed to high longevity risk when guaranteeing guaranteed lifetime payments. As medicine develops and wealth levels rise, longevity risks will increase and induce more adoption of risk mitigation techniques (e.g., expenditure modifications, insurance risk pooling) among individuals and institutions
Investors with longer time horizons should be able to assume greater risk since they have more time to adapt to their circumstances. For example, they can save extra to compensate for any losses or returns that are less than projected.
History shows that, over time, markets go up more often than they go down, thus an investor with a longer time horizon has greater chance to build good return performance.
Longer-term investors are also better equipped to wait for markets to rebound from a period of bad performance, but recovery cannot be guaranteed.
Liquidity
Investors vary in the amount to which they may need to remove money from their holdings. They may need to make a withdrawal to fund a specific purchase or to build a monthly revenue stream. These needs have ramifications for the types of investments chosen. When liquidity is required, the investments will need to be convertible to cash relatively fast and without too much expense (keeping transaction costs and variations in price low) when the cash is needed.
Individual Investors
An person may require that a portion of the portfolio be liquid to pay unanticipated needs. In addition, the individual may have known future liquidity requirements, such as an anticipated future expenditure on children’s schooling or retirement income demands.
Institutional Investors
For an institution, the liquidity restriction often reflects the institution’s liabilities. For example, a pension fund may expect to begin suffering net cash withdrawals at a given time in the future (i.e., when pension payments exceed new contributions to the plan) and will need to sell off some portfolio investments to fulfill those demands. It needs to hold liquid assets in order to do this.
Regulatory Issues
Some sorts of investors have regulatory restrictions that apply to their investments.
For example, in some countries and for certain types of institutional investors, there are restrictions on the proportion of the portfolio that can be invested overseas or in riskier assets, such as shares. Regulations on the holdings of insurance companies are often substantial to protect policy holders.
Taxes
The tax situations of investors differ. Some categories of investors are taxed on their investment returns, and others are not. For example, in many nations, pension funds are excluded from tax on investment returns. Furthermore, the tax treatment of income and capital gains can differ. It is crucial for investment advisers to evaluate an investor’s tax situation and the tax repercussions of alternative investments.
Investors should care about the profits they make after taxes and fees since that is what is available to spend. For example, an investor who is subject to higher tax on dividend income than capital gains will normally choose a portfolio of assets targeting capital growth (i.e., from an increase in value of shares) rather than income (i.e., dividends from shares).
Individuals may also face various tax circumstances for different components of their wealth.
For example, an individual may opt to maintain some assets in a pension account if income and capital gains on assets held in a pension account are tax-exempt or tax-deferred. The investor may choose to hold assets expected to generate capital gains in a taxable investment account if capital gains are taxed at a lower rate than income. Where assets are held can considerably affect an investor’s after-tax profits and wealth building.
Unique Circumstances
Many investors have special requirements or limits not reflected by the traditional categories addressed thus far.
Some investors evaluate how environmental, social, and governance concerns (together known as ESG investing) impact the financial performance of possible investments. Beyond assessing ESG risks associated with an investment, some investors expressly pursue an impact investing approach, which targets investments having beneficial and measurable societal or environmental outcomes (e.g., using social or environmental measures).
Some other investors directly incorporate religious or ethical preferences and exclusions into their investment preferences. For example, some investors may not participate in traditional debt securities because they do not believe they accord with Islamic law.
Investors may also have special requirements that come from the type of their broader investment portfolio or financial circumstances. For example, an individual who is employed by a corporation may seek to limit investment in that company. Limiting investment in securities issued by their workplace would help the employee reduce single-company risk and acquire broader diversification.
Interestingly, many individuals are actually tempted to expand their holdings in their employers’ shares on the grounds of loyalty or familiarity, despite the danger that this strategy carries. Such a strategy can have significant ramifications if the company fails or its financial position falls. For example, many employees of Enron Corporation, a US energy corporation, not only lost their employment but also suffered huge investment losses when Enron went bankrupt.
Institutional investors may also have unique and specific criteria as a result of their objectives and circumstances. For example, a medical foundation may desire to avoid investing in tobacco stocks because it considers encouraging tobacco smoking is antithetical to its objectives of improving health.
Behavioural Finance Considerations
Behavioural finance aims to understand and explain actual investor behaviour, in contrast to theorising about investor behaviour. It varies from traditional (or standard) finance, which is founded on assumptions of how investors and markets should behave. Behavioural finance is about understanding how individuals make decisions, both individually and collectively.
By understanding how investors and markets behave, it may be able to adjust or adapt to these behaviours in order to enhance investment outcomes. In other words, the way investors think and feel affects the way they behave while making investing decisions. Some of these actions are implicitly impacted by prior experiences and personal beliefs to the extent that even competent investors can break from logic and reason.
These factors, which can be classified and characterized as behavioural biases, can alter the way risk is seen and how risk is understood by someone trying to determine a person’s risk tolerance.
Examples of behavioral biases that effect investment decision making vary by individual and institution and are often classed as either emotional or cognitive biases.
EMOTIONAL BIAS
Emotional biases come from instinct or intuition and tend to result from reasoning impacted by feelings.
Example: Loss Aversion Bias
Investors tend to feel the agony of losses more than the pleasure of wins compared with other client categories. Thus, these investors may hold on to failing investments too long, even when they see little hope of a recovery.
COGNITIVE BIAS
Cognitive biases come from basic statistical, information-processing, or memory problems; cognitive errors often result from erroneous reasoning.
Example: Hindsight Bias
Some investors may be prone to hindsight bias, which happens when an investor interprets prior investment outcomes as if they had been predicted. Investment outcomes are rarely, if ever, predicted.
An example of hindsight bias is the response by investors to the financial crisis of 2008. Initially, many saw the housing market’s performance from 2003 to 2007 as ‘normal’ (i.e., not suggestive of a bubble). It was only later that many said, ‘was it not obvious?’ when the market experienced a catastrophe in 2008. Hindsight bias offers investors a false sense of security when making investing decisions, emboldening them to assume excessive risk without perceiving it as such.
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Investment - Investment Policy Statements
It is good practice to record information about the client and the client’s needs in an investment policy statement (IPS). An IPS, for both individual and institutional investors, acts as a guide for the investor and investment manager or adviser regarding what is required of and acceptable in the investment portfolio. An IPS also forms the basis for establishing what constitutes success in managing the portfolio.
The IPS should incorporate the investor’s objectives and any limits that will apply to the portfolio. The investor and manager/adviser should agree on the IPS and evaluate it on a regular basis, often once a year. It should also be revisited when the client encounters a change in circumstances. Creating and revising an IPS is a wonderful opportunity for the investment manager and client to discuss the client’s goals.
A common format for an IPS is to split it into sections covering objectives and restrictions. Each section has its own subsections. The IPS identifies the investor’s conditions and ambitions within the categories of needs and differences described in this course.
Objectives
Return requirement
Risk tolerance
Constraints
Time horizon Liquidity
Regulatory restrictions
Taxes
Unique conditions
A standard IPS comprises objectives and restrictions, but many investors, especially institutional investors, may additionally include procedural and governance issues in the IPS.
The IPS may spell out the role of an investment committee along with its organization and its jurisdiction. It may also lay out the functions of investment managers along with the grounds on which they will be appointed and the criteria on which they will be assessed.
An important aspect of the IPS is to give information that is valuable in determining the types and amounts of assets in which to invest and the way the portfolio will be managed over time.
So, the IPS serves as the basis for developing the optimal portfolio strategies and asset allocations.
Institutional Investors and the Investment Policy Statement
Most institutional investors design and employ a thorough IPS. These statements specify several of the following points:
The overall aims (including return objectives) of the investment strategy and its relevance to the mission of the institution
The risk tolerance of the organisation and its capability for carrying risk
All economic and operational constraints, such as tax concerns, legal and regulatory circumstances, and any other particular requirements
The time horizon over which funds are to be invested
The relative importance of capital preservation and capital growth
The asset types in which the institution is allowed to invest
A target asset allocation that states what proportion of the investment funds will be invested in each asset class
Whether leverage (use of debt) or short positions are authorized
How actively the institution will trade
How investment decisions will be made
The benchmarks against which the institution will measure total investment returns
After the IPS is prepared and required points addressed, the board of the institution or its senior leadership formally accepts the investment and payout policies.
The investment leaders then select whether to handle investments in-house or to contract with one or more investment managers.
Institutional investors that handle their investments in-house hire a team of investment specialists to manage their investments.
Institutional investors who hire outside investment managers may use one manager to oversee all investments or numerous managers. Institutional investors generally use numerous managers to lessen the risk of considerable loss as a result of poor performance by any one manager. Many institutional investors utilize distinct managers for each asset class in which they invest.
By engaging managers who specialise in particular asset classes, the institutional investors receive investment experience and access to investments that a generalist might not have.
It is good practice to record information about the client and the client’s needs in an investment policy statement (IPS). An IPS, for both individual and institutional investors, acts as a guide for the investor and investment manager or adviser regarding what is required of and acceptable in the investment portfolio. An IPS also forms the basis for establishing what constitutes success in managing the portfolio.
The IPS should incorporate the investor’s objectives and any limits that will apply to the portfolio. The investor and manager/adviser should agree on the IPS and evaluate it on a regular basis, often once a year. It should also be revisited when the client encounters a change in circumstances. Creating and revising an IPS is a wonderful opportunity for the investment manager and client to discuss the client’s goals.
A common format for an IPS is to split it into sections covering objectives and restrictions. Each section has its own subsections. The IPS identifies the investor’s conditions and ambitions within the categories of needs and differences described in this course.
Objectives
Return requirement
Risk tolerance
Constraints
Time horizon Liquidity
Regulatory restrictions
Taxes
Unique conditions
A standard IPS comprises objectives and restrictions, but many investors, especially institutional investors, may additionally include procedural and governance issues in the IPS.
The IPS may spell out the role of an investment committee along with its organization and its jurisdiction. It may also lay out the functions of investment managers along with the grounds on which they will be appointed and the criteria on which they will be assessed.
An important aspect of the IPS is to give information that is valuable in determining the types and amounts of assets in which to invest and the way the portfolio will be managed over time.
So, the IPS serves as the basis for developing the optimal portfolio strategies and asset allocations.
Institutional Investors and the Investment Policy Statement
Most institutional investors design and employ a thorough IPS. These statements specify several of the following points:
The overall aims (including return objectives) of the investment strategy and its relevance to the mission of the institution
The risk tolerance of the organisation and its capability for carrying risk
All economic and operational constraints, such as tax concerns, legal and regulatory circumstances, and any other particular requirements
The time horizon over which funds are to be invested
The relative importance of capital preservation and capital growth
The asset types in which the institution is allowed to invest
A target asset allocation that states what proportion of the investment funds will be invested in each asset class
Whether leverage (use of debt) or short positions are authorized
How actively the institution will trade
How investment decisions will be made
The benchmarks against which the institution will measure total investment returns
After the IPS is prepared and required points addressed, the board of the institution or its senior leadership formally accepts the investment and payout policies.
The investment leaders then select whether to handle investments in-house or to contract with one or more investment managers.
Institutional investors that handle their investments in-house hire a team of investment specialists to manage their investments.
Institutional investors who hire outside investment managers may use one manager to oversee all investments or numerous managers. Institutional investors generally use numerous managers to lessen the risk of considerable loss as a result of poor performance by any one manager. Many institutional investors utilize distinct managers for each asset class in which they invest.
By engaging managers who specialise in particular asset classes, the institutional investors receive investment experience and access to investments that a generalist might not have.
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Investment - Risk and Portfolio Diversification
An investment policy statement (IPS) captures information about a customer and the client’s needs. The IPS provides as a reference to what is demanded of and what is acceptable in the investment portfolio. The IPS helps guide asset allocation — that is, which asset classes and how much of each asset class should be included in the investor’s portfolio.
Academic research have suggested that asset allocation is the most important factor of portfolio return. Most investors — both individual and institutional — keep a broad range of investments rather than a portfolio concentrated in just a few investments. A fundamental reason for this diversity is the need to manage risk, which is congruent with the aphorism to not ‘put all your eggs in one basket’.
Systematic Risk, Specific Risk, and Diversification
How well investment risk is managed is a crucial factor of the success of investment management. Risk occurs when there is uncertainty, implying that a variety of outcomes are possible from a single scenario or activity.
In financial terminology, risk is the potential that the actual realised return on an investment will be something other than the return originally predicted on the investment. There will be instances when the return fails to match an investor’s expectations and times when the return exceeds expectations. Fluctuations in the prices and values of investments (capital gains and losses) represent the risk of investing. Income (e.g., dividends and interest) may also differ from what was expected.
Most investors seek larger returns and reduced risks. That is, people desire better outcomes and more certainty, all other things being equal. The trade-off between risk and return is a key issue in investment management. Typically, the larger the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return.
Systematic and Specific Risk
The returns on investments, such as equities, bonds, and real estate, will be affected by overall economic conditions. Returns will also be affected by issues that are specific to the particular investment.
Systematic risk
The risk caused by general economic conditions is characterized as systemic or market risk since the danger emanates from the wider economic system. For example, if the economy enters a recession, many companies will notice a fall in their revenues and profits.
Specific risk
Risk that is distinctive to a certain firm or investment is variously termed as specific, idiosyncratic, non-systematic, or unsystematic risk. Examples include the positive share price response when a company releases a successful new product (e.g., the Apple iPad) or the negative response to the news that a promising new treatment has failed in trials.
The distinction between systemic and specific risk is essential because the two categories of risk have different implications for investors. Investors can lower specific risk by holding a number of different securities in their portfolios. Holding a variety of securities that are not associated diversifies away specific risk. The amount to which two asset classes (or securities) move together is indicated by the statistical measure of correlation.The stronger the correlation between the returns on asset classes (or securities), the more comparable their price movements will be.
Investors cannot diversify away systematic risk. They can do nothing to minimize systematic risk because all investments will be influenced to some extent by systematic risk — for instance, a recession. Diversifying an equity portfolio by adding alternative forms of investments, such as real estate, will not eliminate systematic risk because rents and real estate values are affected by the same broad economic variables as the stock market.
Because systematic risk cannot be avoided or spread away and because risk is undesirable, investors have to be compensated for taking on systematic risk. More exposure to systemic risk tends to be associated with higher predicted returns over the long run.
Portfolio theory implies that taking on more specific risk does not necessarily lead to higher returns on average because specific risk can be diversified away. But some investors may try to locate shares that they think to outperform (to produce higher returns than predicted based on their risk) and invest in them rather than diversifying. In the process, investors take on specific risk; if they turn out to be correct, they may get a bigger return as a result of taking on more risk.
Diversification
Diversification is one of the most important aspects of investing. When assets and/or asset classes with varied characteristics are mixed in a portfolio, the overall level of risk is often lowered.
Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets. Provided that the two assets are less than completely linked, the risk of the portfolio (measured by the standard deviation of returns) will be smaller than the weighted average of the risk of the two assets individually. Overall, this indicates the risk–return trade-off, which is a key issue for investors, is better for a portfolio of assets than for individual assets.
Most investors have more than two securities in their portfolios. Adding more assets to a portfolio will lower risk through diversification, although eventually the additional benefits begin to lessen. The exhibit below demonstrates the degrees of risk — total, particular, and systematic — for portfolios of shares picked at random from all of the shares in the US market.
Specific risk is decreased by merging additional shares, but as the portfolio moves beyond 30 shares, the incremental risk reduction becomes minimal and the accompanying trading expenses may outweigh any incremental advantage of risk reduction. The display illustrates the ideas of unique risk and diversification. Specific risk is highest at the left side of the exhibit (one share) and lowest at the right side of the display since much of the specific risk is spread away.
Portfolio Risk
The display assumes randomly picked shares. But there is the potential for higher risk reduction when shares with low correlation with each other are chosen.
Combining diverse asset classes can also boost diversification and lower a portfolio’s risk by minimizing specific risk. For example, an investor can combine assets in multiple stock and bond markets with investments in real estate and commodities to lower the overall risk of a portfolio.
An investment policy statement (IPS) captures information about a customer and the client’s needs. The IPS provides as a reference to what is demanded of and what is acceptable in the investment portfolio. The IPS helps guide asset allocation — that is, which asset classes and how much of each asset class should be included in the investor’s portfolio.
Academic research have suggested that asset allocation is the most important factor of portfolio return. Most investors — both individual and institutional — keep a broad range of investments rather than a portfolio concentrated in just a few investments. A fundamental reason for this diversity is the need to manage risk, which is congruent with the aphorism to not ‘put all your eggs in one basket’.
Systematic Risk, Specific Risk, and Diversification
How well investment risk is managed is a crucial factor of the success of investment management. Risk occurs when there is uncertainty, implying that a variety of outcomes are possible from a single scenario or activity.
In financial terminology, risk is the potential that the actual realised return on an investment will be something other than the return originally predicted on the investment. There will be instances when the return fails to match an investor’s expectations and times when the return exceeds expectations. Fluctuations in the prices and values of investments (capital gains and losses) represent the risk of investing. Income (e.g., dividends and interest) may also differ from what was expected.
Most investors seek larger returns and reduced risks. That is, people desire better outcomes and more certainty, all other things being equal. The trade-off between risk and return is a key issue in investment management. Typically, the larger the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return.
Systematic and Specific Risk
The returns on investments, such as equities, bonds, and real estate, will be affected by overall economic conditions. Returns will also be affected by issues that are specific to the particular investment.
Systematic risk
The risk caused by general economic conditions is characterized as systemic or market risk since the danger emanates from the wider economic system. For example, if the economy enters a recession, many companies will notice a fall in their revenues and profits.
Specific risk
Risk that is distinctive to a certain firm or investment is variously termed as specific, idiosyncratic, non-systematic, or unsystematic risk. Examples include the positive share price response when a company releases a successful new product (e.g., the Apple iPad) or the negative response to the news that a promising new treatment has failed in trials.
The distinction between systemic and specific risk is essential because the two categories of risk have different implications for investors. Investors can lower specific risk by holding a number of different securities in their portfolios. Holding a variety of securities that are not associated diversifies away specific risk. The amount to which two asset classes (or securities) move together is indicated by the statistical measure of correlation.The stronger the correlation between the returns on asset classes (or securities), the more comparable their price movements will be.
Investors cannot diversify away systematic risk. They can do nothing to minimize systematic risk because all investments will be influenced to some extent by systematic risk — for instance, a recession. Diversifying an equity portfolio by adding alternative forms of investments, such as real estate, will not eliminate systematic risk because rents and real estate values are affected by the same broad economic variables as the stock market.
Because systematic risk cannot be avoided or spread away and because risk is undesirable, investors have to be compensated for taking on systematic risk. More exposure to systemic risk tends to be associated with higher predicted returns over the long run.
Portfolio theory implies that taking on more specific risk does not necessarily lead to higher returns on average because specific risk can be diversified away. But some investors may try to locate shares that they think to outperform (to produce higher returns than predicted based on their risk) and invest in them rather than diversifying. In the process, investors take on specific risk; if they turn out to be correct, they may get a bigger return as a result of taking on more risk.
Diversification
Diversification is one of the most important aspects of investing. When assets and/or asset classes with varied characteristics are mixed in a portfolio, the overall level of risk is often lowered.
Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets. Provided that the two assets are less than completely linked, the risk of the portfolio (measured by the standard deviation of returns) will be smaller than the weighted average of the risk of the two assets individually. Overall, this indicates the risk–return trade-off, which is a key issue for investors, is better for a portfolio of assets than for individual assets.
Most investors have more than two securities in their portfolios. Adding more assets to a portfolio will lower risk through diversification, although eventually the additional benefits begin to lessen. The exhibit below demonstrates the degrees of risk — total, particular, and systematic — for portfolios of shares picked at random from all of the shares in the US market.
Specific risk is decreased by merging additional shares, but as the portfolio moves beyond 30 shares, the incremental risk reduction becomes minimal and the accompanying trading expenses may outweigh any incremental advantage of risk reduction. The display illustrates the ideas of unique risk and diversification. Specific risk is highest at the left side of the exhibit (one share) and lowest at the right side of the display since much of the specific risk is spread away.
Portfolio Risk
The display assumes randomly picked shares. But there is the potential for higher risk reduction when shares with low correlation with each other are chosen.
Combining diverse asset classes can also boost diversification and lower a portfolio’s risk by minimizing specific risk. For example, an investor can combine assets in multiple stock and bond markets with investments in real estate and commodities to lower the overall risk of a portfolio.
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Investment - Asset Allocation and Portfolio Construction
After generating the investment policy statement (IPS), which comprises — among other facts — an investor’s desire and ability to take risk, the asset allocation of the portfolio is defined.
This determination entails decisions regarding whether asset classes are suitable (e.g., global stocks, domestic government bonds, commodities, or domestic real estate investment trusts) and the proportion of the portfolio to invest in each asset class. In some circumstances, the asset distribution decision is documented as part of the IPS; in other cases, asset allocation is recognized as part of the following execution of the IPS.
The chosen strategic asset allocation is intended to match the investor’s long-term risk and return objectives. An investor may determine the strategic asset allocation and simply keep a portfolio for the life of the investment. If the investor does so, the proportions of the portfolio will likely vary from the original weights specified because the different asset classes provide different rates of return over time and their values thus increase or fall by different amounts. As a result, the portfolio has to be changed through a process called rebalancing.
Rebalancing entails selling some of the assets that have increased as a proportion of the portfolio and putting the proceeds into the holdings that have declined as a proportion of the portfolio. Because there are trading costs connected with rebalancing, most investors will not rebalance on a continuing basis, but will instead rebalance at specified intervals or weightings.
Tactical Asset Allocation
Although the chosen strategic asset allocation is expected to match the investor’s objectives over the long term, there are instances when shorter-term changes in asset class returns can be utilized to potentially boost portfolio returns. A short-term change among asset classes is known as tactical asset allocation.
Strategic Asset Allocation
Strategic asset allocation is the long-term mix of assets that is expected to suit the investor’s objectives. The desired overall risk and return profile of the portfolio is a consideration in selecting the strategic asset allocation. A portfolio with a strategic asset allocation dominated by stocks would be expected to have a greater return and be more volatile than a portfolio dominated by bonds because bonds normally have lower risk than equities and so provide lower returns. The strategic asset allocation that is suitable for one investor may not be suitable for another.
Academic research have revealed that strategic asset selection considerably affects the average return of a portfolio. Thus, asset allocation demands considerable attention from investors, investment managers, and investment counselors. Consider the following example of strategic asset allocation.
Example: Strategic Asset Allocation
An institutional investor requires a 7% return on its investments. The investing committee decides to invest in global equities and in European government bonds. At the time the investment is made, European government bonds are yielding 4%, and the committee’s projection for the long-term return on the global equities market is 9%.
A portfolio allocation of 40% bonds and 60% equity generates an estimated return of 7%: (0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7%
The committee has to examine the level of risk suggested by this asset allocation. If the committee is not comfortable with the risk, the return criterion may need to be adjusted. The portfolio composition can be modified as bond yields vary and the committee revises its forecasts for the return on the global equity.
Strategic asset allocation often involves investment managers to evaluate the projected risk and return of each asset type. Historical returns can be used as a guide, but forecasts need to be forward-looking. Managers also need to establish the correlation of returns between the asset classes so they can quantify the diversification benefits that may be realized by combining the various assets in a portfolio.
To illustrate, we will extend the preceding scenario in which an investor has a strategic asset allocation of 60% global equities and 40% European government bonds. The investment manager may think the global equities market is overvalued and likely to provide bad returns in the short run. In response, the manager could modify the asset allocation to, for example, 50% equities and 50% bonds. If the manager’s forecast is true, this 50/50 tactical allocation will perform better in the near term than the strategic asset allocation of 60/40. The management will have added return for the investment compared with maintaining the strategic weights on a static basis.
But anticipating markets is tough, and tactical allocation does not always favor the investor. The difficulty of financial forecasting means investors may prefer to retain their strategic asset allocation within established parameters. For example, an appropriate strategic asset allocation may be judged to be 56%–64% global stocks and 36%–44% European government bonds, rather than 60% global equities and 40% European government bonds. Such ranges allow for some tactical asset allocation and lessen the need for and expense of frequent portfolio rebalance.
An investor or manager often employs a range of tools and information to make tactical allocation decisions. The decisions may be based on one of the following:
Fundamental studies of economic and political factors and their probable effects on market returns
Market value measures relative to prior data
Trends and momentum in marketplaces
When considering tactically adjusting a portfolio’s asset allocation, a manager may look at the strength of the economy and expected future trends to acquire a view on how the central bank might change interest rates and on what might happen to company profits. The manager may next look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges. The management could also look at stock and bond market patterns as a way of measuring investor mood.
Tactical asset allocation represents an attempt to enhance value to a portfolio by departing from the strategic asset allocation. Tactical asset allocation is a form of active portfolio management.
After generating the investment policy statement (IPS), which comprises — among other facts — an investor’s desire and ability to take risk, the asset allocation of the portfolio is defined.
This determination entails decisions regarding whether asset classes are suitable (e.g., global stocks, domestic government bonds, commodities, or domestic real estate investment trusts) and the proportion of the portfolio to invest in each asset class. In some circumstances, the asset distribution decision is documented as part of the IPS; in other cases, asset allocation is recognized as part of the following execution of the IPS.
The chosen strategic asset allocation is intended to match the investor’s long-term risk and return objectives. An investor may determine the strategic asset allocation and simply keep a portfolio for the life of the investment. If the investor does so, the proportions of the portfolio will likely vary from the original weights specified because the different asset classes provide different rates of return over time and their values thus increase or fall by different amounts. As a result, the portfolio has to be changed through a process called rebalancing.
Rebalancing entails selling some of the assets that have increased as a proportion of the portfolio and putting the proceeds into the holdings that have declined as a proportion of the portfolio. Because there are trading costs connected with rebalancing, most investors will not rebalance on a continuing basis, but will instead rebalance at specified intervals or weightings.
Tactical Asset Allocation
Although the chosen strategic asset allocation is expected to match the investor’s objectives over the long term, there are instances when shorter-term changes in asset class returns can be utilized to potentially boost portfolio returns. A short-term change among asset classes is known as tactical asset allocation.
Strategic Asset Allocation
Strategic asset allocation is the long-term mix of assets that is expected to suit the investor’s objectives. The desired overall risk and return profile of the portfolio is a consideration in selecting the strategic asset allocation. A portfolio with a strategic asset allocation dominated by stocks would be expected to have a greater return and be more volatile than a portfolio dominated by bonds because bonds normally have lower risk than equities and so provide lower returns. The strategic asset allocation that is suitable for one investor may not be suitable for another.
Academic research have revealed that strategic asset selection considerably affects the average return of a portfolio. Thus, asset allocation demands considerable attention from investors, investment managers, and investment counselors. Consider the following example of strategic asset allocation.
Example: Strategic Asset Allocation
An institutional investor requires a 7% return on its investments. The investing committee decides to invest in global equities and in European government bonds. At the time the investment is made, European government bonds are yielding 4%, and the committee’s projection for the long-term return on the global equities market is 9%.
A portfolio allocation of 40% bonds and 60% equity generates an estimated return of 7%: (0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7%
The committee has to examine the level of risk suggested by this asset allocation. If the committee is not comfortable with the risk, the return criterion may need to be adjusted. The portfolio composition can be modified as bond yields vary and the committee revises its forecasts for the return on the global equity.
Strategic asset allocation often involves investment managers to evaluate the projected risk and return of each asset type. Historical returns can be used as a guide, but forecasts need to be forward-looking. Managers also need to establish the correlation of returns between the asset classes so they can quantify the diversification benefits that may be realized by combining the various assets in a portfolio.
To illustrate, we will extend the preceding scenario in which an investor has a strategic asset allocation of 60% global equities and 40% European government bonds. The investment manager may think the global equities market is overvalued and likely to provide bad returns in the short run. In response, the manager could modify the asset allocation to, for example, 50% equities and 50% bonds. If the manager’s forecast is true, this 50/50 tactical allocation will perform better in the near term than the strategic asset allocation of 60/40. The management will have added return for the investment compared with maintaining the strategic weights on a static basis.
But anticipating markets is tough, and tactical allocation does not always favor the investor. The difficulty of financial forecasting means investors may prefer to retain their strategic asset allocation within established parameters. For example, an appropriate strategic asset allocation may be judged to be 56%–64% global stocks and 36%–44% European government bonds, rather than 60% global equities and 40% European government bonds. Such ranges allow for some tactical asset allocation and lessen the need for and expense of frequent portfolio rebalance.
An investor or manager often employs a range of tools and information to make tactical allocation decisions. The decisions may be based on one of the following:
Fundamental studies of economic and political factors and their probable effects on market returns
Market value measures relative to prior data
Trends and momentum in marketplaces
When considering tactically adjusting a portfolio’s asset allocation, a manager may look at the strength of the economy and expected future trends to acquire a view on how the central bank might change interest rates and on what might happen to company profits. The manager may next look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges. The management could also look at stock and bond market patterns as a way of measuring investor mood.
Tactical asset allocation represents an attempt to enhance value to a portfolio by departing from the strategic asset allocation. Tactical asset allocation is a form of active portfolio management.
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Investment - Passive and Active Management
Beyond choosing on asset allocation, an investor must determine whether to utilize a passive or an active management strategy to asset selection.
Passive managers manage a portfolio designed to replicate the performance of a given benchmark.
Active managers aim to add value to a portfolio by selecting investments that are predicted, on the basis of analysis, to outperform a given benchmark.
The choice between the two approaches often rests 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 tied to the investor’s perceptions about the efficiency of the markets being invested in. An investor may elect 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 basic values and return prospects of the assets they represent. For example, in a stock market environment, a company with outstanding prospects should have a high stock valuation, which indicates the future earnings that would likely accrue to the shareholders.
A corporation with bad prospects will have a low valuation to reflect the predicted low future profitability of the company. If stock markets are perceived to be informationally efficient, the investor will assume there is little reason to actively manage stock market investments because share prices already reflect the potential of the underlying companies. In other words, there is little to uncover via more inquiry. In contrast, in an inefficient market some shares may be over- or undervalued relative to the company’s prospects, and an investor may be rewarded with excess profits by properly identifying such shares.
Sometimes, whole markets — rather than simply individual shares — can be priced inefficiently. Some investors claim that stock markets in industrialized economies are reasonably efficient, but that those in emerging economies are less so. They claim that public information flows may not be as wide or accurate in emerging economies and that it is feasible for some investors to access and use information that is not available to others.
This condition could emerge because there may be less market regulation in emerging economies than in more developed economies or because there may be a dearth of experienced analysts researching markets in emerging economies. Similarly, some investors say that shares of smaller companies are less efficiently priced than shares of larger companies because fewer investors and analysts take the time to analyze tiny companies in detail, and information is less available. The most efficient markets tend to be those with a large number of active, informed members.
The marketplaces for such investments as real estate or private equity may not be efficient for numerous reasons. For instance, information on these investments may not be publicly available and trading is less active and done privately rather than on a public market in which prices and volumes may be observed. As a result, some investors may have access to information and transactions that are not available to other investors. In circumstances when inefficiency is known to exist, it is reasonable to expect that active management may be a successful solution.
PASSIVE MANAGEMENT
Passive investment managers strive to match the return and risk of a benchmark. Benchmarks include broad market indexes, indices for a specific market segment, and specifically developed benchmarks. Passive investment managers seek to limit tracking inaccuracy. The tracking error is the deviation of the return on the portfolio from the return on the benchmark being monitored. Passive managers may strive to fully replicate the benchmark by holding all the securities in the benchmark in amounts equivalent to their weighting in the benchmark.
ACTIVE MANAGEMENT
Active investment managers utilize a range of approaches. They may attempt to identify assets that will outperform the benchmark. These active managers focus on selecting specific shares or assets in an asset class or classes. Active managers may also try to timing a market (buying when they believe the market is low and selling when they believe the market is overvalued). Tactical asset allocation is an example of trying to time markets.
Factors Needed for Active Management to Be Successful
Active management is a tough endeavor, yet there are managers that have excellent long-term records of accomplishment. For active managers to be continuously successful, they have to be better than ordinary investors at appraising the potential of investments. When active managers buy a security or investment because their analysis suggests it has strong return potential, they may be buying it from another active manager who believes the prospects for the asset are poor.
For active managers to find outperforming stocks 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 interpret the information. The capacity to accomplish this is tough because so many other investors have access to the same information and tools.
In many markets, corporate disclosure requirements ensure that information about company fundamentals must be made available to all investors at the same time. In reality, rules often restrict selective sharing of key information on corporate prospects or performance. As mentioned in Course 1, Industry Overview and Structure, investors trading based on material nonpublic information — known as insider trading — face serious legal and criminal implications in most jurisdictions.
Also, for active management to be successful, any mispricing of investments has to be big enough to offset the costs of exploiting the mispricing. Investing in an undervalued security is only worthwhile if the excess return covers the cost of the research required to find the undervaluation and the trading fees involved in investing in the investment. Accurately forecasting mispricing is challenging since prices normally should already represent most publicly available information regarding basic values.
Much academic and practitioner research has shown that most active managers do not regularly outperform the market over lengthy time periods, even accounting for fees and expenses. Unfortunately, identifying active managers who will exceed the market in the future is generally as difficult as predicting specific assets that will outperform the market.
Choosing between Passive and Active Management
Is investing passively in an index, such as the Hang Seng Index, the S&P 500 Index, or the FTSE 100 Index, the greatest method to enhance your wealth? Or is hiring an active investment manager with a record of past performance a better option? Unfortunately, it is never possible to tell for sure in advance. But the choice between passive and active management is a major problem for investors and the decision must be evaluated carefully.
Passive management is often cheaper to adopt than active management since properly duplicating or tracking a benchmark takes fewer analytical resources than researching and discovering investments with greater return potential. The passive strategy involves some ability, such as determining which investments to include in the benchmark and their corresponding values and weights in the benchmark. Although the costs of passive management are lower than the expenses of active management, the return achieved by the passive investor will often be less than the index return because of costs.
Passive management of equity portfolios is a well-established discipline and duplicating an equity market index is very uncomplicated. But for some markets, like as real estate, in which all properties are unique and trading is done in private transactions rather than on a public stock exchange, it is less clear how a passive method may be applied. There may not be a suitable index for passive managers to track.
In addition, real estate assets themselves have to be managed (kept, rented, remodeled, and so on) in a way that stock investments do not. So, most investments in real estate are actively handled to some level. A same reasoning applies to private equity and venture capital.
Active techniques involve a more extensive investigation of each relevant investment or asset class, which is costly because investment firms need skilled workers and/or expensive technology. Active management often also has higher transaction costs because of more frequent trading in the portfolio. If active management does generate returns that are higher than the benchmark, the excess return may compensate for the increased employee, technology, and transaction costs and the net returns to the investor may be higher.
Proponents of active management say that good active managers can more than cover their expenses and hence give net benefit to investors. Conversely, proponents of passive management say that the difficulty of discovering superior investments means it is not worth paying greater fees for that effort and that passive management will give higher net-of-costs returns over the longer run. Concerns about the costs, the average or below-average performance of most active managers, and the difficulties of finding active investment managers who may succeed in the future have made passive investment techniques increasingly popular over time.
Despite these concerns, active management nonetheless remains popular.
As indicated previously, an investor may elect to use a passive approach in some markets and an active approach in other markets depending on an assessment of the efficiency of each market.
Beyond choosing on asset allocation, an investor must determine whether to utilize a passive or an active management strategy to asset selection.
Passive managers manage a portfolio designed to replicate the performance of a given benchmark.
Active managers aim to add value to a portfolio by selecting investments that are predicted, on the basis of analysis, to outperform a given benchmark.
The choice between the two approaches often rests 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 tied to the investor’s perceptions about the efficiency of the markets being invested in. An investor may elect 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 basic values and return prospects of the assets they represent. For example, in a stock market environment, a company with outstanding prospects should have a high stock valuation, which indicates the future earnings that would likely accrue to the shareholders.
A corporation with bad prospects will have a low valuation to reflect the predicted low future profitability of the company. If stock markets are perceived to be informationally efficient, the investor will assume there is little reason to actively manage stock market investments because share prices already reflect the potential of the underlying companies. In other words, there is little to uncover via more inquiry. In contrast, in an inefficient market some shares may be over- or undervalued relative to the company’s prospects, and an investor may be rewarded with excess profits by properly identifying such shares.
Sometimes, whole markets — rather than simply individual shares — can be priced inefficiently. Some investors claim that stock markets in industrialized economies are reasonably efficient, but that those in emerging economies are less so. They claim that public information flows may not be as wide or accurate in emerging economies and that it is feasible for some investors to access and use information that is not available to others.
This condition could emerge because there may be less market regulation in emerging economies than in more developed economies or because there may be a dearth of experienced analysts researching markets in emerging economies. Similarly, some investors say that shares of smaller companies are less efficiently priced than shares of larger companies because fewer investors and analysts take the time to analyze tiny companies in detail, and information is less available. The most efficient markets tend to be those with a large number of active, informed members.
The marketplaces for such investments as real estate or private equity may not be efficient for numerous reasons. For instance, information on these investments may not be publicly available and trading is less active and done privately rather than on a public market in which prices and volumes may be observed. As a result, some investors may have access to information and transactions that are not available to other investors. In circumstances when inefficiency is known to exist, it is reasonable to expect that active management may be a successful solution.
PASSIVE MANAGEMENT
Passive investment managers strive to match the return and risk of a benchmark. Benchmarks include broad market indexes, indices for a specific market segment, and specifically developed benchmarks. Passive investment managers seek to limit tracking inaccuracy. The tracking error is the deviation of the return on the portfolio from the return on the benchmark being monitored. Passive managers may strive to fully replicate the benchmark by holding all the securities in the benchmark in amounts equivalent to their weighting in the benchmark.
ACTIVE MANAGEMENT
Active investment managers utilize a range of approaches. They may attempt to identify assets that will outperform the benchmark. These active managers focus on selecting specific shares or assets in an asset class or classes. Active managers may also try to timing a market (buying when they believe the market is low and selling when they believe the market is overvalued). Tactical asset allocation is an example of trying to time markets.
Factors Needed for Active Management to Be Successful
Active management is a tough endeavor, yet there are managers that have excellent long-term records of accomplishment. For active managers to be continuously successful, they have to be better than ordinary investors at appraising the potential of investments. When active managers buy a security or investment because their analysis suggests it has strong return potential, they may be buying it from another active manager who believes the prospects for the asset are poor.
For active managers to find outperforming stocks 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 interpret the information. The capacity to accomplish this is tough because so many other investors have access to the same information and tools.
In many markets, corporate disclosure requirements ensure that information about company fundamentals must be made available to all investors at the same time. In reality, rules often restrict selective sharing of key information on corporate prospects or performance. As mentioned in Course 1, Industry Overview and Structure, investors trading based on material nonpublic information — known as insider trading — face serious legal and criminal implications in most jurisdictions.
Also, for active management to be successful, any mispricing of investments has to be big enough to offset the costs of exploiting the mispricing. Investing in an undervalued security is only worthwhile if the excess return covers the cost of the research required to find the undervaluation and the trading fees involved in investing in the investment. Accurately forecasting mispricing is challenging since prices normally should already represent most publicly available information regarding basic values.
Much academic and practitioner research has shown that most active managers do not regularly outperform the market over lengthy time periods, even accounting for fees and expenses. Unfortunately, identifying active managers who will exceed the market in the future is generally as difficult as predicting specific assets that will outperform the market.
Choosing between Passive and Active Management
Is investing passively in an index, such as the Hang Seng Index, the S&P 500 Index, or the FTSE 100 Index, the greatest method to enhance your wealth? Or is hiring an active investment manager with a record of past performance a better option? Unfortunately, it is never possible to tell for sure in advance. But the choice between passive and active management is a major problem for investors and the decision must be evaluated carefully.
Passive management is often cheaper to adopt than active management since properly duplicating or tracking a benchmark takes fewer analytical resources than researching and discovering investments with greater return potential. The passive strategy involves some ability, such as determining which investments to include in the benchmark and their corresponding values and weights in the benchmark. Although the costs of passive management are lower than the expenses of active management, the return achieved by the passive investor will often be less than the index return because of costs.
Passive management of equity portfolios is a well-established discipline and duplicating an equity market index is very uncomplicated. But for some markets, like as real estate, in which all properties are unique and trading is done in private transactions rather than on a public stock exchange, it is less clear how a passive method may be applied. There may not be a suitable index for passive managers to track.
In addition, real estate assets themselves have to be managed (kept, rented, remodeled, and so on) in a way that stock investments do not. So, most investments in real estate are actively handled to some level. A same reasoning applies to private equity and venture capital.
Active techniques involve a more extensive investigation of each relevant investment or asset class, which is costly because investment firms need skilled workers and/or expensive technology. Active management often also has higher transaction costs because of more frequent trading in the portfolio. If active management does generate returns that are higher than the benchmark, the excess return may compensate for the increased employee, technology, and transaction costs and the net returns to the investor may be higher.
Proponents of active management say that good active managers can more than cover their expenses and hence give net benefit to investors. Conversely, proponents of passive management say that the difficulty of discovering superior investments means it is not worth paying greater fees for that effort and that passive management will give higher net-of-costs returns over the longer run. Concerns about the costs, the average or below-average performance of most active managers, and the difficulties of finding active investment managers who may succeed in the future have made passive investment techniques increasingly popular over time.
Despite these concerns, active management nonetheless remains popular.
As indicated previously, an investor may elect to use a passive approach in some markets and an active approach in other markets depending on an assessment of the efficiency of each market.
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Investment - Identifying and Capturing Market Inefficiencies
Active investment managers employ numerous approaches to try to identify future success. Managers utilizing fundamental analysis focus on macroeconomic, industry-specific, and company-specific aspects that make stocks and assets valuable. 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 influence future market prices.
Some active managers employ statistical or quantitative models to try to identify shares that are likely to outperform or underperform. In practice, many managers employ a blend of the strategies mentioned in the following sections. Based on their analysis, active managers purchase assets that are likely to generate superior returns and sell assets that are expected to underperform.
Fundamental Analysis
Active managers typically aim to find and monetize market inefficiencies through fundamental analysis. For equity investors, this procedure includes doing a detailed review of a company’s business strategy, its prospects, and its financial status. This analysis may involve meeting corporate executives and interviewing them about their strategy and the future of the company.
Analysts must take care not to breach laws and rules when acquiring information. Their purpose is to uncover firms that have greater prospects than the stock market price reflects. Typically, an analyst or investment manager undertakes some type of fundamental analysis to arrive at an estimated value for a company’s shares. If the share price is significantly below the anticipated 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 considered as the present value of all the cash flows the security will generate in the future. For example, Investment Instruments, that investors can estimate the worth of a stock by discounting all the dividends they expect to get while they keep the stock and adding the proceeds from selling the stock. Value that is estimated this way is called the stock’s fundamental value or intrinsic value. Although basic values are not observable, many active investment managers work hard to appropriately assess them. Managers utilizing fundamental analysis operate on the idea that security market prices tend to gravitate towards their estimations of basic values. They can yield spectacular returns when they precisely estimate values and make the necessary investments before other market participants.
To assess basic values, they must project future cash flows and determine the rates at which these cash flows are discounted. Managers utilizing fundamental analysis take into account various issues when formulating investing opinions. The problems most relevant to their opinions differ depending to the sort of asset they are examining.
For example, when assessing fixed-income securities (such as bonds, notes, and bills), managers consider borrowers’ ability and willingness to pay their debts – that is, borrowers’ creditworthiness and trustworthiness. Lenders regard borrowers to be creditworthy if they think that the borrowers will be able to pay interest, principal, and preferred dividends when due. They consider borrowers to be trustworthy if they think that borrowers will organize their affairs to ensure that they can and will make these payments. Managers consider financial data and historical borrowing experiences to determine if debtors are creditworthy and trustworthy.
When assessing shares, they pay particular attention to an issuer’s future potential for making money and producing valuable assets. Among many other factors, they analyze the demand for the company’s products, cost of manufacturing those items, profit margins of the company and if the margins are sustainable, and the competitiveness of the company and whether it can remain competitive.
Technical and Behavioural Analysis
Managers using technical analysis analyze market information, including price patterns and trading volumes, whereas managers using behavioural analysis focus on signs of market sentiment, such as manufacturers’ new orders or indices of consumer expectations.
Some investment managers employ a technical approach, aiming to examine price and trading volume trends in the stock market to find equities that may outperform or underperform.
For example, an active manager who believes in momentum will aim to invest in shares that have lately been increasing in the market. Momentum is predicated on the concept that a rising share will continue to rise. Other managers might look for evidence of imbalance between the possible buyers and sellers of a share to try to predict which direction the share is likely to move.
An rise in demand or a decrease in supply will often lead prices to climb. Similarly, a fall in demand or an increase in supply will often lead prices to decline. 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 create statistical models to try to discover shares that are likely to outperform. By evaluating data, they find factors that have historically been related with share price outperformance.
For example, the study might show 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 predicted earnings growth likely to outperform. This information can then be utilized to seek for shares that show those traits. Managers utilizing this method are typically termed ‘quants’ because of the quantitative models they deploy.
As indicated previously, managers may employ a combination of these sorts of analysis. Also, depending on the asset, asset class, or market being examined, the approach(es) used and the particular variables of interest will differ.
Active investment managers employ numerous approaches to try to identify future success. Managers utilizing fundamental analysis focus on macroeconomic, industry-specific, and company-specific aspects that make stocks and assets valuable. 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 influence future market prices.
Some active managers employ statistical or quantitative models to try to identify shares that are likely to outperform or underperform. In practice, many managers employ a blend of the strategies mentioned in the following sections. Based on their analysis, active managers purchase assets that are likely to generate superior returns and sell assets that are expected to underperform.
Fundamental Analysis
Active managers typically aim to find and monetize market inefficiencies through fundamental analysis. For equity investors, this procedure includes doing a detailed review of a company’s business strategy, its prospects, and its financial status. This analysis may involve meeting corporate executives and interviewing them about their strategy and the future of the company.
Analysts must take care not to breach laws and rules when acquiring information. Their purpose is to uncover firms that have greater prospects than the stock market price reflects. Typically, an analyst or investment manager undertakes some type of fundamental analysis to arrive at an estimated value for a company’s shares. If the share price is significantly below the anticipated 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 considered as the present value of all the cash flows the security will generate in the future. For example, Investment Instruments, that investors can estimate the worth of a stock by discounting all the dividends they expect to get while they keep the stock and adding the proceeds from selling the stock. Value that is estimated this way is called the stock’s fundamental value or intrinsic value. Although basic values are not observable, many active investment managers work hard to appropriately assess them. Managers utilizing fundamental analysis operate on the idea that security market prices tend to gravitate towards their estimations of basic values. They can yield spectacular returns when they precisely estimate values and make the necessary investments before other market participants.
To assess basic values, they must project future cash flows and determine the rates at which these cash flows are discounted. Managers utilizing fundamental analysis take into account various issues when formulating investing opinions. The problems most relevant to their opinions differ depending to the sort of asset they are examining.
For example, when assessing fixed-income securities (such as bonds, notes, and bills), managers consider borrowers’ ability and willingness to pay their debts – that is, borrowers’ creditworthiness and trustworthiness. Lenders regard borrowers to be creditworthy if they think that the borrowers will be able to pay interest, principal, and preferred dividends when due. They consider borrowers to be trustworthy if they think that borrowers will organize their affairs to ensure that they can and will make these payments. Managers consider financial data and historical borrowing experiences to determine if debtors are creditworthy and trustworthy.
When assessing shares, they pay particular attention to an issuer’s future potential for making money and producing valuable assets. Among many other factors, they analyze the demand for the company’s products, cost of manufacturing those items, profit margins of the company and if the margins are sustainable, and the competitiveness of the company and whether it can remain competitive.
Technical and Behavioural Analysis
Managers using technical analysis analyze market information, including price patterns and trading volumes, whereas managers using behavioural analysis focus on signs of market sentiment, such as manufacturers’ new orders or indices of consumer expectations.
Some investment managers employ a technical approach, aiming to examine price and trading volume trends in the stock market to find equities that may outperform or underperform.
For example, an active manager who believes in momentum will aim to invest in shares that have lately been increasing in the market. Momentum is predicated on the concept that a rising share will continue to rise. Other managers might look for evidence of imbalance between the possible buyers and sellers of a share to try to predict which direction the share is likely to move.
An rise in demand or a decrease in supply will often lead prices to climb. Similarly, a fall in demand or an increase in supply will often lead prices to decline. 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 create statistical models to try to discover shares that are likely to outperform. By evaluating data, they find factors that have historically been related with share price outperformance.
For example, the study might show 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 predicted earnings growth likely to outperform. This information can then be utilized to seek for shares that show those traits. Managers utilizing this method are typically termed ‘quants’ because of the quantitative models they deploy.
As indicated previously, managers may employ a combination of these sorts of analysis. Also, depending on the asset, asset class, or market being examined, the approach(es) used and the particular variables of interest will differ.
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Investment - Definition and Classification of Risks
It is crucial for firms to have a disciplined procedure that helps them detect and plan for a wide range of hazards. Although risk management is commonly considered as a specialist activity, an effective risk management approach will embrace the entire firm and flow down from senior management to all employees, giving them advice in carrying out their roles. Any action you take as an employee may effect your company’s risk profile, even if these acts are ‘only’ routine daily operations.
An inadvertent error can cause severe damage to a firm, therefore it is crucial that you have a thorough grasp of the types of risks organizations in the investing industry encounter and that you learn how these risks are managed.
Definition and Classification of Risks
Risk can take numerous forms. Although there is no universal classification of hazards, this section identifies typical risks that companies in the investment industry are susceptible to.
Definition of Risk
Risk derives from uncertainty. It can be described as the effect of unpredictable future occurrences on a corporation or on the outcomes the organization accomplishes. One of these outcomes is the company’s profitability, which is why the impacts of risk on profit and rates of return are typically studied.
Events that have or could have a negative effect, resulting to losses or negative rates of return, tend to be stressed in discussions about risk. Some of these events are external to the company.
For example, a bank with a large portfolio of commercial loans may face huge losses if the economy falls into recession and business defaults increase. Other incidents, such as internal fraud or network failure, are internal to the company.
But not all results from events are negative; certain occurrences might have a beneficial effect on the organization, creating potential for benefits.
For example, a company that takes the risk of investing in a country with strong capital controls (or controls on flows in financial markets) may benefit if the capital controls are abolished and the company becomes one of the few foreign companies licensed to purchase and sell securities in that country.
So, the assessment of risk needs to incorporate opportunities as well as dangers.
Classification of Risks
Risks are classified according to the source of uncertainty. There is a huge list of sources of uncertainty, so there is a correspondingly long list of dangers. Relatively well-defined categories of risk exist, but no standard risk classification system applies to all firms since risks should be classified in a manner that helps managers make better decisions in the context of their particular company and its environment.
All companies confront the danger of not being able to operate successfully in a particular competitive environment, often because of a shift in market conditions.
For example, a company’s ability to grow and remain profitable may be affected by changes in client preferences, the evolution of the competitive landscape, or product and technological improvements.
There are three dangers that companies in the investing industry are often susceptible to.
Operational risk is the risk of losses from inadequate or failed personnel, systems, and internal rules and procedures as well as from external events that are outside the control of the organization but that affect its operations.
Examples of operational risk include human errors, internal fraud, system malfunctions, technology failure, and contractual conflicts.
Compliance risk is the risk that a corporation fails to follow all applicable rules, laws, and regulations and faces sanctions as a result.
Investment Risk Investment risk is the risk connected with investing that occurs from volatility in the value of investments.
It is crucial for firms to have a disciplined procedure that helps them detect and plan for a wide range of hazards. Although risk management is commonly considered as a specialist activity, an effective risk management approach will embrace the entire firm and flow down from senior management to all employees, giving them advice in carrying out their roles. Any action you take as an employee may effect your company’s risk profile, even if these acts are ‘only’ routine daily operations.
An inadvertent error can cause severe damage to a firm, therefore it is crucial that you have a thorough grasp of the types of risks organizations in the investing industry encounter and that you learn how these risks are managed.
Definition and Classification of Risks
Risk can take numerous forms. Although there is no universal classification of hazards, this section identifies typical risks that companies in the investment industry are susceptible to.
Definition of Risk
Risk derives from uncertainty. It can be described as the effect of unpredictable future occurrences on a corporation or on the outcomes the organization accomplishes. One of these outcomes is the company’s profitability, which is why the impacts of risk on profit and rates of return are typically studied.
Events that have or could have a negative effect, resulting to losses or negative rates of return, tend to be stressed in discussions about risk. Some of these events are external to the company.
For example, a bank with a large portfolio of commercial loans may face huge losses if the economy falls into recession and business defaults increase. Other incidents, such as internal fraud or network failure, are internal to the company.
But not all results from events are negative; certain occurrences might have a beneficial effect on the organization, creating potential for benefits.
For example, a company that takes the risk of investing in a country with strong capital controls (or controls on flows in financial markets) may benefit if the capital controls are abolished and the company becomes one of the few foreign companies licensed to purchase and sell securities in that country.
So, the assessment of risk needs to incorporate opportunities as well as dangers.
Classification of Risks
Risks are classified according to the source of uncertainty. There is a huge list of sources of uncertainty, so there is a correspondingly long list of dangers. Relatively well-defined categories of risk exist, but no standard risk classification system applies to all firms since risks should be classified in a manner that helps managers make better decisions in the context of their particular company and its environment.
All companies confront the danger of not being able to operate successfully in a particular competitive environment, often because of a shift in market conditions.
For example, a company’s ability to grow and remain profitable may be affected by changes in client preferences, the evolution of the competitive landscape, or product and technological improvements.
There are three dangers that companies in the investing industry are often susceptible to.
Operational risk is the risk of losses from inadequate or failed personnel, systems, and internal rules and procedures as well as from external events that are outside the control of the organization but that affect its operations.
Examples of operational risk include human errors, internal fraud, system malfunctions, technology failure, and contractual conflicts.
Compliance risk is the risk that a corporation fails to follow all applicable rules, laws, and regulations and faces sanctions as a result.
Investment Risk Investment risk is the risk connected with investing that occurs from volatility in the value of investments.
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Investment - The Risk Management Process
A solid risk management plan helps firms lower the frequency and severity of unfavorable occurrences and boosts management’s capacity to achieve opportunities. The implications of inadequate risk management include investment losses and even bankruptcy.
Other costly outcomes are also possible, such as the following:
Sanctions for the breaking of regulations
Loss of licences to provide financial services
Damage to the company’s reputation and the reputations of its personnel
A risk management process provides a structure for detecting and prioritising risks, assessing their likelihood and possible severity, taking preventive or mitigating steps if necessary, and constantly monitoring and making modifications.
A company’s risk management approach is not always consistently planned; it often evolves in reaction to crises by incorporating the lessons learned and the new regulatory obligations that sometimes accompany these disasters. But well-run firms benefit from people and systems that enable forward-looking attention to developing threats.
Definition of Risk Management
Risk management is an iterative process used by businesses to support the identification and management of risk (or uncertainty) and limit the changes and/or impacts of unfavorable events while boosting the realisation of opportunities and the ability to achieve company objectives. These objectives may take numerous shapes, but they are often driven by a company’s mission and strategy.
A common corporate purpose is to create value in a business environment that is usually riddled with uncertainty. So, a major purpose of the risk management process is to assist managers deal with this uncertainty and recognize the threats and opportunities their firm confronts.
One of the key functions of risk management is to establish the correct balance between risk and return. Shareholders in a firm or investors in a fund have put their money for the promise of a return at some risk level. By limiting the effect of events that may derail the company’s capacity to fulfill its objectives while profiting from opportunities to grow the company profitably, risk management plays a vital role in delivering value for these shareholders and investors.
The engagement of the board of directors and senior management in risk management is crucial because they determine corporate strategy and strategic business objectives. Although directors and top managers are in responsible of determining the right degree of risk to support the corporate plan, risk management should engage all employees.
One person delivering an erroneous or dishonest appraisal can ruin the reputation of their firm and possibly lead to its extinction. Reputations take years to develop, but they may be lost in an instant. Markets are more linked, and media and the internet can disseminate the news of a mistake or scandal around the globe in a matter of minutes.
Thus, risk management is crucial to protecting reputations as well as sustaining confidence among market players and trust in the financial system.
Steps in the Risk Management Process
Setting Objective
Setting objectives is an important aspect of business planning. An important element in the setting of objectives is the company's risk tolerance. Risk tolerance is the level of risk that the company is able and willing to take on.
The ability to handle risk is mostly driven by the company's financial health and depends on its level of earnings, cash flows, and equity capital. Its readiness to take on risk, which is sometimes called its risk appetite, depends on its attitude towards risk and its risk culture.
The next phase in the risk management process is to recognize and identify occurrences that may affect attaining the company's aim. The purpose of risk management is to strive to capture the complete range of risk, even hidden or unrecognized ones. But no matter how hard firms attempt to identify and decrease dangers, they can never be totally discovered or removed.
thereby, risk management provides a rigorous framework to assist firms plan for unfavorable occurrences, anticipate their occurrence as early as feasible if they do materialise and thereby mitigate their effects. The process of evaluating potential dangers might also disclose hidden value increasing opportunities.
No matter what form risk takes, two parts of it are routinely addressed, in particular for unwanted events : the predicted frequency of the event and the expected severity of its repercussions. In practice, the selection of key risk measurements is important for the risk management function to be proactive and predictive.
Key risk measures should provide a warning when risk levels are growing. They demand the gathering and processing of data from many internal and external sources. The types of essential risk measures differ among industries and firms, and they need to be reviewed often to ensure that the measures are still relevant and sensitive to risk events.
The next phase in risk management is to design responses to cope with the hazards identified in the previous step. For each risk, management must determine an appropriate response and implement activities to match the company's risk profile with its risk tolerance.
A risk management method that enables managers to identify between the risks that are most likely to give opportunities and the risks that are most likely to be destructive helps firms earn greater returns.
In fact, investment firms define internal risk limits that include the company's overall risk tolerance and risk management strategy — for example, by specifying the maximum quantity of a risky security that can be held or the maximum aggregate exposure to one asset category or to one counterparty. Defining limitations and then regulating and monitoring those limits allows organizations to implement risk response techniques.
Taking action in response to risk entails a range of regulating and monitoring tasks that must be completed in a timely manner. At some point, risks must be aggregated and managed at the firm level, bringing together individual hazards into an overall risk exposure.
Enterprise risk management (ERM) lets a corporation manage all its risks together in an integrated approach rather than handling each risk independently. The advantage of this strategy is that it links risk management with objectives at all levels of the firm, from the corporate level to the business unit level to the project level.
No system, activity, or process can be precisely managed or completely risk free. Despite developments in technology, individuals still play a large part in a company’s decision making. Human involvement is often the difference between a successful investing firm and an average one, as we will explain in the next session.
A solid risk management plan helps firms lower the frequency and severity of unfavorable occurrences and boosts management’s capacity to achieve opportunities. The implications of inadequate risk management include investment losses and even bankruptcy.
Other costly outcomes are also possible, such as the following:
Sanctions for the breaking of regulations
Loss of licences to provide financial services
Damage to the company’s reputation and the reputations of its personnel
A risk management process provides a structure for detecting and prioritising risks, assessing their likelihood and possible severity, taking preventive or mitigating steps if necessary, and constantly monitoring and making modifications.
A company’s risk management approach is not always consistently planned; it often evolves in reaction to crises by incorporating the lessons learned and the new regulatory obligations that sometimes accompany these disasters. But well-run firms benefit from people and systems that enable forward-looking attention to developing threats.
Definition of Risk Management
Risk management is an iterative process used by businesses to support the identification and management of risk (or uncertainty) and limit the changes and/or impacts of unfavorable events while boosting the realisation of opportunities and the ability to achieve company objectives. These objectives may take numerous shapes, but they are often driven by a company’s mission and strategy.
A common corporate purpose is to create value in a business environment that is usually riddled with uncertainty. So, a major purpose of the risk management process is to assist managers deal with this uncertainty and recognize the threats and opportunities their firm confronts.
One of the key functions of risk management is to establish the correct balance between risk and return. Shareholders in a firm or investors in a fund have put their money for the promise of a return at some risk level. By limiting the effect of events that may derail the company’s capacity to fulfill its objectives while profiting from opportunities to grow the company profitably, risk management plays a vital role in delivering value for these shareholders and investors.
The engagement of the board of directors and senior management in risk management is crucial because they determine corporate strategy and strategic business objectives. Although directors and top managers are in responsible of determining the right degree of risk to support the corporate plan, risk management should engage all employees.
One person delivering an erroneous or dishonest appraisal can ruin the reputation of their firm and possibly lead to its extinction. Reputations take years to develop, but they may be lost in an instant. Markets are more linked, and media and the internet can disseminate the news of a mistake or scandal around the globe in a matter of minutes.
Thus, risk management is crucial to protecting reputations as well as sustaining confidence among market players and trust in the financial system.
Steps in the Risk Management Process
Setting Objective
Setting objectives is an important aspect of business planning. An important element in the setting of objectives is the company's risk tolerance. Risk tolerance is the level of risk that the company is able and willing to take on.
The ability to handle risk is mostly driven by the company's financial health and depends on its level of earnings, cash flows, and equity capital. Its readiness to take on risk, which is sometimes called its risk appetite, depends on its attitude towards risk and its risk culture.
The next phase in the risk management process is to recognize and identify occurrences that may affect attaining the company's aim. The purpose of risk management is to strive to capture the complete range of risk, even hidden or unrecognized ones. But no matter how hard firms attempt to identify and decrease dangers, they can never be totally discovered or removed.
thereby, risk management provides a rigorous framework to assist firms plan for unfavorable occurrences, anticipate their occurrence as early as feasible if they do materialise and thereby mitigate their effects. The process of evaluating potential dangers might also disclose hidden value increasing opportunities.
No matter what form risk takes, two parts of it are routinely addressed, in particular for unwanted events : the predicted frequency of the event and the expected severity of its repercussions. In practice, the selection of key risk measurements is important for the risk management function to be proactive and predictive.
Key risk measures should provide a warning when risk levels are growing. They demand the gathering and processing of data from many internal and external sources. The types of essential risk measures differ among industries and firms, and they need to be reviewed often to ensure that the measures are still relevant and sensitive to risk events.
The next phase in risk management is to design responses to cope with the hazards identified in the previous step. For each risk, management must determine an appropriate response and implement activities to match the company's risk profile with its risk tolerance.
A risk management method that enables managers to identify between the risks that are most likely to give opportunities and the risks that are most likely to be destructive helps firms earn greater returns.
In fact, investment firms define internal risk limits that include the company's overall risk tolerance and risk management strategy — for example, by specifying the maximum quantity of a risky security that can be held or the maximum aggregate exposure to one asset category or to one counterparty. Defining limitations and then regulating and monitoring those limits allows organizations to implement risk response techniques.
Taking action in response to risk entails a range of regulating and monitoring tasks that must be completed in a timely manner. At some point, risks must be aggregated and managed at the firm level, bringing together individual hazards into an overall risk exposure.
Enterprise risk management (ERM) lets a corporation manage all its risks together in an integrated approach rather than handling each risk independently. The advantage of this strategy is that it links risk management with objectives at all levels of the firm, from the corporate level to the business unit level to the project level.
No system, activity, or process can be precisely managed or completely risk free. Despite developments in technology, individuals still play a large part in a company’s decision making. Human involvement is often the difference between a successful investing firm and an average one, as we will explain in the next session.
- Published on
Investment - Risk Management Functions
Risk management duties differ by organization, however it is customary for companies in the investment industry to have a stand-alone risk management function with a senior head, generally named the chief risk officer, who is capable of independent judgement and action.
The chief risk officer often reports directly to the board of directors. The purpose of building a robust independent risk management function is to build checks and balances to guarantee that risks are seriously considered and balanced against other objectives, such as profitability.
Companies will typically employ a three-lines-of-defence risk management methodology.
Three Lines of Defence
Frontline Employees / supervisors during their daily responsibilities operate as first line of protection.
Risk management and compliance groups operate as a second line of defence, aiding and advising employees and managers while maintaining independence.
Internal audits operate as third line of defence.
Internal audit is an independent role. Internal auditors implement risk-based internal audit programmes, digging into the minutiae of business operations and ensuring that information technology and accounting systems appropriately reflect transactions. Proactive auditors may also advise managers on ways to improve risk management, controls, and efficiency.
Best practice indicates that internal auditors should report directly to the audit committee of the board of directors to ensure their independence. Thus, risk and audit committees of the board will commonly receive presentations from the heads of risk management, compliance, and internal audit.
Benefits and Costs of Risk Management
Risk management delivers a wide range of benefits to a company:
Supporting strategic and business planning
Incorporating risk considerations in all business activities to ensure that the company’s risk profile is consistent with its risk tolerance
Limiting the amount of risk a company takes, limiting excessive risk taking and potential related losses, and lowering the possibility of bankruptcy
Bringing greater discipline to the company’s operations, which leads to more effective business procedures, better controls, and a more efficient deployment of capital
Recognising responsibility and accountability
mproving performance evaluation and ensuring that the remuneration system is compatible with the company’s risk tolerance
Enhancing the flow of information throughout the firm, which results in better communication, enhanced transparency, and higher knowledge and understanding of risk
Assisting with the early detection of unlawful and fraudulent actions, thereby supporting compliance procedures and audit testing
The expenses of creating risk management systems include tangible costs, such as the following:
Hiring dedicated risk management personnel
Establishing procedures
Investing in systems
The costs of creating risk management systems often include intangible costs, such as slower decision making and missed opportunities.
So, allocation of resources to risk management should be based on a cost–benefit analysis. It is difficult to weigh the costs and benefits of risk management precisely because it is impossible to observe, let alone estimate, the cost of potential catastrophes that are averted.
It is only in hindsight that the cost–benefit trade-offs can be discovered. A case in point is Barings Bank’s bankruptcy in 1995, which was sparked by trading losses hidden in the bank’s Singapore unit. At the time, there was no suitable and effective method for reconciling customer orders and trades on a global scale.
Such a method could have exposed the losses before they wiped out all of the bank’s equity capital. It is believed that installing this system would have cost roughly GBP10 million, a minor price to pay compared to the GBP827 million loss that brought down Barings.
Risk management duties differ by organization, however it is customary for companies in the investment industry to have a stand-alone risk management function with a senior head, generally named the chief risk officer, who is capable of independent judgement and action.
The chief risk officer often reports directly to the board of directors. The purpose of building a robust independent risk management function is to build checks and balances to guarantee that risks are seriously considered and balanced against other objectives, such as profitability.
Companies will typically employ a three-lines-of-defence risk management methodology.
Three Lines of Defence
Frontline Employees / supervisors during their daily responsibilities operate as first line of protection.
Risk management and compliance groups operate as a second line of defence, aiding and advising employees and managers while maintaining independence.
Internal audits operate as third line of defence.
Internal audit is an independent role. Internal auditors implement risk-based internal audit programmes, digging into the minutiae of business operations and ensuring that information technology and accounting systems appropriately reflect transactions. Proactive auditors may also advise managers on ways to improve risk management, controls, and efficiency.
Best practice indicates that internal auditors should report directly to the audit committee of the board of directors to ensure their independence. Thus, risk and audit committees of the board will commonly receive presentations from the heads of risk management, compliance, and internal audit.
Benefits and Costs of Risk Management
Risk management delivers a wide range of benefits to a company:
Supporting strategic and business planning
Incorporating risk considerations in all business activities to ensure that the company’s risk profile is consistent with its risk tolerance
Limiting the amount of risk a company takes, limiting excessive risk taking and potential related losses, and lowering the possibility of bankruptcy
Bringing greater discipline to the company’s operations, which leads to more effective business procedures, better controls, and a more efficient deployment of capital
Recognising responsibility and accountability
mproving performance evaluation and ensuring that the remuneration system is compatible with the company’s risk tolerance
Enhancing the flow of information throughout the firm, which results in better communication, enhanced transparency, and higher knowledge and understanding of risk
Assisting with the early detection of unlawful and fraudulent actions, thereby supporting compliance procedures and audit testing
The expenses of creating risk management systems include tangible costs, such as the following:
Hiring dedicated risk management personnel
Establishing procedures
Investing in systems
The costs of creating risk management systems often include intangible costs, such as slower decision making and missed opportunities.
So, allocation of resources to risk management should be based on a cost–benefit analysis. It is difficult to weigh the costs and benefits of risk management precisely because it is impossible to observe, let alone estimate, the cost of potential catastrophes that are averted.
It is only in hindsight that the cost–benefit trade-offs can be discovered. A case in point is Barings Bank’s bankruptcy in 1995, which was sparked by trading losses hidden in the bank’s Singapore unit. At the time, there was no suitable and effective method for reconciling customer orders and trades on a global scale.
Such a method could have exposed the losses before they wiped out all of the bank’s equity capital. It is believed that installing this system would have cost roughly GBP10 million, a minor price to pay compared to the GBP827 million loss that brought down Barings.
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Investment - Operational Risk
Operational risk is the risk of losses from inadequate or failed personnel, systems, and internal rules and procedures as well as from external events that are outside the control of the organization but that affect its operations.
Managing People
Human failures range from unintentional errors to fraudulent behaviors. Many firms are subject to occupational fraud (also termed internal fraud or employee fraud), which is when an employee abuses their position for personal benefit by misappropriating the company’s assets or resources. In a poll carried out by the Association for Certified Fraud Examiners (ACFE), anti-fraud professionals calculated that globally organizations lose, on average, 5% of their yearly revenues to fraud.
One example of operational risk that includes a human component and is more frequent in the financial services business than in any other industry is rogue trading.
Rogue trading refers to circumstances in which traders bypass management controls and place unauthorized deals, at times creating huge losses for the companies they work for. Rogue trading may involve fraudulent trading done for personal enrichment or to make up losses.
Example: Libor Manipulation Scandal
One of the most comprehensive criminal investigations and prosecutions that arose in the wake of the 2008 financial crisis was a premeditated attempt by numerous banks and certain employees to manipulate the London Interbank Offered Rate known as Libor. At that time, Libor was the worldwide accepted benchmark rate used by banks to establish interest rates on a myriad of loans (consumer and financial) and depended on self-reported estimates of borrowing costs from banks.
Prosecutors in many jurisdictions determined that banks had collaborated by pushing their estimations higher or lower in a bid to profit from connected assets tied to the rate. In the end, many banks across the world would plead guilty and were fined billions, while scores of individuals were pursued and charged with criminal activity.
Mitigating Risk
Banks, like other corporations, have tried to learn from past disasters and plug the holes in its systems and controls to prevent similar catastrophes from recurring. The bankruptcy of Barings Bank in 1995 exposed the consequences of not segregating front- and back-office activities appropriately.
In the modest bank branch of Barings in Singapore, the same staff managed both types of business. An initial trading loss (a front-office activity) due of a human error was hidden in the accounting system (a back-office activity), and subsequent losses mounted until they surpassed the bank’s equity capital. Following Barings’ failure, banks were compelled to establish a clear division between their front and back offices.
Companies can decrease operational risks through education by clearly conveying rules and processes and by establishing efficient and effective internal controls. Good human resource management techniques are also crucial; employing the right people and motivating them with the right incentives are well-known factors for success.
To reduce the risk of recruiting the incorrect personnel, companies often take numerous safeguards, such as the following:
Conducting background checks, such as verifying criminal records and disciplinary records with regulators for new employment
Verifying qualifications and past work experience
Performing personality assessment tests
Getting character references to establish suitability
Although these safeguards may appear to be conventional, research have revealed that inconsistencies between presented and actual qualifications are prevalent. Cases in which background checks of senior executives were not correctly done are often reported. Because of a loss of trust, some of these executives had to resign when the truth was known, even if they had performed satisfactorily in their jobs.
Risk taking should also be addressed in the structure of compensation, for example when setting bonus payments for employees. It is particularly critical for employees who expose the organization to large risks, such as traders and investment professionals. A fair compensation system should take into account the level of risk incurred for a given level of return and should reward those who accomplish returns without incurring excessive risks.
An example of an incentive that could lead to deviant behaviour is rewarding traders for earnings regardless of the risks they take. This technique would provide them all the upside for trading gains, but less downside for taking on risks and for trading losses. In actuality, traders creating big losses frequently lose their jobs and reputations, although they usually do not have to pay back much compared with the income they previously earned.
Some authorities are already implementing new compensation systems that incorporate deferred remuneration to take into consideration long-term performance as well as claw-back provisions, wherein employees may have to refund their bonuses if claimed profitable transactions result in losses later.
Managing Systems
Companies rely substantially on information technology (IT) systems. Consequently, technology has become an increasingly major source of operational risk. Automated processes can lessen the incidence and severity of operational failures, but they are not flawless. Failures of IT and communication systems can paralyse business activities or severely diminish their efficiency, affecting the company’s profitability via reduced revenues, higher costs, or a combination of both.
IT networks are inherently vulnerable to disturbances and outside intervention owing to technical limits and human factors. One source of danger is the attitude of employees who do not follow corporate policies and, for instance, download illegal software for personal or professional use.
The disadvantages of this technique include harmful viruses and unauthorized, and perhaps incompatible, software infiltrating enterprise systems. In addition, IT departments are in a constant war with hackers who exploit holes to enter systems.
Key controls to secure systems and corporate information include the following:
Establishing and disseminating internal policies for users and IT technical staff Creating acceptable security standards and configurations for systems
Allocating appropriate manpower and technical resources to ensure a well-controlled IT environment
The security of secret information is also vital in the investment industry. Data privacy has lately gained in popularity due to a series of situations in which companies and government agencies allowed people’s private information to enter the public domain, exposing them to the danger of fraud.
A corporation should understand how data are produced and flow internally, classify the information by sensitivity, estimate the risks of data loss, and adopt suitable preventative measures. Many countries have strict laws and regulations for securing customer data, coupled with significant consequences for breaking these laws and regulations.
Complying with Internal Policies and Procedures
The structure of a company varies with size and the business activities it is engaged in, but there are aspects common to all firms. For example, power and authority are delegated and duties assigned within most corporations. In smaller entrepreneurial organizations, such assignments may be communicated informally, with individuals recognizing their respective positions and degrees of authority.
In larger and more complicated firms, the responsibilities and degrees of authority will be explicitly defined and the business processes written out in more detail, frequently contained in corporate management systems. Policies and procedures should expressly set out the delegation of authority and identify clear roles and accountability. These definitions constitute the basis for the monitoring of and control of business operations and provide feedback mechanisms.
The division of duties is a fundamental notion that international firms and regulators, along with other authorities in many nations, need and urge. As discussed before, a clear distinction needs to exist between front and back offices. In accounting departments, there should also be a clear separation between those who enter items into the accounts and those who reconcile the bank statements with the cash balances in the accounting system.
This separation of roles decreases the chance that personnel who possess cash may commit fraud or pilfer funds. Compliance and internal audit responsibilities are crucial to verifying that staff are truly following internal policies and procedures.
Managing the Business Environment
The sort of environment in which a company operates might add levels of uncertainty that need to be addressed.
Political risk is the risk that a change in the dominant political party of a country would lead to changes in policies that can affect anything from monetary policy (money supply, interest rates, and credit) and fiscal policy (taxation) to investment incentives, public projects, and procurement.
Some industries are significantly controlled by governments that, for example, regulate natural resources or set pricing of raw material inputs or outputs. In some circumstances, a change in administration or policy can impact the value of an investment. Political risk is inherent in all countries and should always be considered, even if it is deemed to be relatively remote.
Legal risk is the chance that an external party would sue the company for breach of contract or other infractions. A corporation should assess how it identifies and conforms to the legal responsibilities it has undertaken
The function of an in-house legal professional is vital to controlling legal risk. Most sections of a corporation have relations with external parties, such as deal counterparties, business partners, suppliers, and service providers. An key control in managing the legal risk of these external ties is to have legal professionals analyze every contract.
Companies should explicitly allocate authority and indicate who should evaluate and approve certain type of contracts. The most major deals normally require clearance at the level of the board of directors. Another solution is to use template agreements and standard contract terms and conditions that have been examined and approved by the legal staff.
The preservation of records, documents, and other forms of communication must also be in conformity with legal standards for all relevant jurisdictions.
Settlement risk (or counterparty risk) is the danger that while closing a transaction, a corporation fulfills one side of the contract, such as sending a security or money, but the counterparty does not complete its side of the deal as agreed, frequently because it has declared bankruptcy. This risk is sometimes also called Herstatt risk because of an incident in 1974 when the German Herstatt Bank ceased operations after counterparties had honoured their obligation to transfer Deutsche Marks to Herstatt, but before Herstatt honoured its obligation to transfer the equivalent amount in US dollars back to these counterparties.
Although there are usually legal procedures to compel a counterparty to meet its obligations, such actions are costly and time consuming. A counterparty is more likely to find it difficult to fulfil its obligations during adverse economic times or when bankruptcy is imminent than during successful periods. In the case of bankruptcy, it may take months or years to receive assets through a bankruptcy resolution procedure and the proceeds may only be a fraction of the original nominal amount of debt.
It is vital to identify the risks inherent in bilateral arrangements from those in transactions contracted through central counterparties, such as clearing institutions. Clearing houses may step in to accept the risk of a counterparty failing to meet its contractual obligations. Other measures to mitigate this risk are margin requirements or standardised agreements.
Operational risk is the risk of losses from inadequate or failed personnel, systems, and internal rules and procedures as well as from external events that are outside the control of the organization but that affect its operations.
Managing People
Human failures range from unintentional errors to fraudulent behaviors. Many firms are subject to occupational fraud (also termed internal fraud or employee fraud), which is when an employee abuses their position for personal benefit by misappropriating the company’s assets or resources. In a poll carried out by the Association for Certified Fraud Examiners (ACFE), anti-fraud professionals calculated that globally organizations lose, on average, 5% of their yearly revenues to fraud.
One example of operational risk that includes a human component and is more frequent in the financial services business than in any other industry is rogue trading.
Rogue trading refers to circumstances in which traders bypass management controls and place unauthorized deals, at times creating huge losses for the companies they work for. Rogue trading may involve fraudulent trading done for personal enrichment or to make up losses.
Example: Libor Manipulation Scandal
One of the most comprehensive criminal investigations and prosecutions that arose in the wake of the 2008 financial crisis was a premeditated attempt by numerous banks and certain employees to manipulate the London Interbank Offered Rate known as Libor. At that time, Libor was the worldwide accepted benchmark rate used by banks to establish interest rates on a myriad of loans (consumer and financial) and depended on self-reported estimates of borrowing costs from banks.
Prosecutors in many jurisdictions determined that banks had collaborated by pushing their estimations higher or lower in a bid to profit from connected assets tied to the rate. In the end, many banks across the world would plead guilty and were fined billions, while scores of individuals were pursued and charged with criminal activity.
Mitigating Risk
Banks, like other corporations, have tried to learn from past disasters and plug the holes in its systems and controls to prevent similar catastrophes from recurring. The bankruptcy of Barings Bank in 1995 exposed the consequences of not segregating front- and back-office activities appropriately.
In the modest bank branch of Barings in Singapore, the same staff managed both types of business. An initial trading loss (a front-office activity) due of a human error was hidden in the accounting system (a back-office activity), and subsequent losses mounted until they surpassed the bank’s equity capital. Following Barings’ failure, banks were compelled to establish a clear division between their front and back offices.
Companies can decrease operational risks through education by clearly conveying rules and processes and by establishing efficient and effective internal controls. Good human resource management techniques are also crucial; employing the right people and motivating them with the right incentives are well-known factors for success.
To reduce the risk of recruiting the incorrect personnel, companies often take numerous safeguards, such as the following:
Conducting background checks, such as verifying criminal records and disciplinary records with regulators for new employment
Verifying qualifications and past work experience
Performing personality assessment tests
Getting character references to establish suitability
Although these safeguards may appear to be conventional, research have revealed that inconsistencies between presented and actual qualifications are prevalent. Cases in which background checks of senior executives were not correctly done are often reported. Because of a loss of trust, some of these executives had to resign when the truth was known, even if they had performed satisfactorily in their jobs.
Risk taking should also be addressed in the structure of compensation, for example when setting bonus payments for employees. It is particularly critical for employees who expose the organization to large risks, such as traders and investment professionals. A fair compensation system should take into account the level of risk incurred for a given level of return and should reward those who accomplish returns without incurring excessive risks.
An example of an incentive that could lead to deviant behaviour is rewarding traders for earnings regardless of the risks they take. This technique would provide them all the upside for trading gains, but less downside for taking on risks and for trading losses. In actuality, traders creating big losses frequently lose their jobs and reputations, although they usually do not have to pay back much compared with the income they previously earned.
Some authorities are already implementing new compensation systems that incorporate deferred remuneration to take into consideration long-term performance as well as claw-back provisions, wherein employees may have to refund their bonuses if claimed profitable transactions result in losses later.
Managing Systems
Companies rely substantially on information technology (IT) systems. Consequently, technology has become an increasingly major source of operational risk. Automated processes can lessen the incidence and severity of operational failures, but they are not flawless. Failures of IT and communication systems can paralyse business activities or severely diminish their efficiency, affecting the company’s profitability via reduced revenues, higher costs, or a combination of both.
IT networks are inherently vulnerable to disturbances and outside intervention owing to technical limits and human factors. One source of danger is the attitude of employees who do not follow corporate policies and, for instance, download illegal software for personal or professional use.
The disadvantages of this technique include harmful viruses and unauthorized, and perhaps incompatible, software infiltrating enterprise systems. In addition, IT departments are in a constant war with hackers who exploit holes to enter systems.
Key controls to secure systems and corporate information include the following:
Establishing and disseminating internal policies for users and IT technical staff Creating acceptable security standards and configurations for systems
Allocating appropriate manpower and technical resources to ensure a well-controlled IT environment
The security of secret information is also vital in the investment industry. Data privacy has lately gained in popularity due to a series of situations in which companies and government agencies allowed people’s private information to enter the public domain, exposing them to the danger of fraud.
A corporation should understand how data are produced and flow internally, classify the information by sensitivity, estimate the risks of data loss, and adopt suitable preventative measures. Many countries have strict laws and regulations for securing customer data, coupled with significant consequences for breaking these laws and regulations.
Complying with Internal Policies and Procedures
The structure of a company varies with size and the business activities it is engaged in, but there are aspects common to all firms. For example, power and authority are delegated and duties assigned within most corporations. In smaller entrepreneurial organizations, such assignments may be communicated informally, with individuals recognizing their respective positions and degrees of authority.
In larger and more complicated firms, the responsibilities and degrees of authority will be explicitly defined and the business processes written out in more detail, frequently contained in corporate management systems. Policies and procedures should expressly set out the delegation of authority and identify clear roles and accountability. These definitions constitute the basis for the monitoring of and control of business operations and provide feedback mechanisms.
The division of duties is a fundamental notion that international firms and regulators, along with other authorities in many nations, need and urge. As discussed before, a clear distinction needs to exist between front and back offices. In accounting departments, there should also be a clear separation between those who enter items into the accounts and those who reconcile the bank statements with the cash balances in the accounting system.
This separation of roles decreases the chance that personnel who possess cash may commit fraud or pilfer funds. Compliance and internal audit responsibilities are crucial to verifying that staff are truly following internal policies and procedures.
Managing the Business Environment
The sort of environment in which a company operates might add levels of uncertainty that need to be addressed.
Political risk is the risk that a change in the dominant political party of a country would lead to changes in policies that can affect anything from monetary policy (money supply, interest rates, and credit) and fiscal policy (taxation) to investment incentives, public projects, and procurement.
Some industries are significantly controlled by governments that, for example, regulate natural resources or set pricing of raw material inputs or outputs. In some circumstances, a change in administration or policy can impact the value of an investment. Political risk is inherent in all countries and should always be considered, even if it is deemed to be relatively remote.
Legal risk is the chance that an external party would sue the company for breach of contract or other infractions. A corporation should assess how it identifies and conforms to the legal responsibilities it has undertaken
The function of an in-house legal professional is vital to controlling legal risk. Most sections of a corporation have relations with external parties, such as deal counterparties, business partners, suppliers, and service providers. An key control in managing the legal risk of these external ties is to have legal professionals analyze every contract.
Companies should explicitly allocate authority and indicate who should evaluate and approve certain type of contracts. The most major deals normally require clearance at the level of the board of directors. Another solution is to use template agreements and standard contract terms and conditions that have been examined and approved by the legal staff.
The preservation of records, documents, and other forms of communication must also be in conformity with legal standards for all relevant jurisdictions.
Settlement risk (or counterparty risk) is the danger that while closing a transaction, a corporation fulfills one side of the contract, such as sending a security or money, but the counterparty does not complete its side of the deal as agreed, frequently because it has declared bankruptcy. This risk is sometimes also called Herstatt risk because of an incident in 1974 when the German Herstatt Bank ceased operations after counterparties had honoured their obligation to transfer Deutsche Marks to Herstatt, but before Herstatt honoured its obligation to transfer the equivalent amount in US dollars back to these counterparties.
Although there are usually legal procedures to compel a counterparty to meet its obligations, such actions are costly and time consuming. A counterparty is more likely to find it difficult to fulfil its obligations during adverse economic times or when bankruptcy is imminent than during successful periods. In the case of bankruptcy, it may take months or years to receive assets through a bankruptcy resolution procedure and the proceeds may only be a fraction of the original nominal amount of debt.
It is vital to identify the risks inherent in bilateral arrangements from those in transactions contracted through central counterparties, such as clearing institutions. Clearing houses may step in to accept the risk of a counterparty failing to meet its contractual obligations. Other measures to mitigate this risk are margin requirements or standardised agreements.