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Lay out how large investors, pension funds for instance, go about investing.

FRM® Part II · Risk Management and Investment Management · VaR and Risk Budgeting in Investment Management · FRM2.IM.6.c

The idea

Large investors such as pension funds invest top-down. First an asset-liability study examines liabilities, sponsor finances and risk tolerance. It sets the policy mix, the long-term allocation across asset classes. Then a benchmark is chosen for each asset class. Then the money is delegated to several external managers, each with a mandate, a benchmark, guidelines and a risk limit, some passive and some active. Finally the plan monitors managers and the total fund against benchmarks and budgets. The policy mix drives most of total fund risk. Active management usually adds a small share of the variance. Because managers are watched one by one, the plan must also aggregate across them, since active bets can offset or overlap. Exam point: the order is policy mix, benchmarks, managers, monitoring, and aggregation sits with the plan.

A practice question

From the question bank, with the reason each wrong option is wrong.

In the typical top-down process followed by a large pension fund, which step comes first?

  1. Hiring external managers for each asset class.Why not: Manager selection follows the allocation decision; it cannot be done before the policy mix is set.
  2. Setting detailed security-level limits and guidelines for each external manager.Why not: Guidelines for each manager are drafted late, once mandates and benchmarks exist.
  3. An asset-liability study setting the policy mix. - correct
  4. Back-testing each manager's performance against its benchmark.Why not: Performance evaluation is monitoring, which comes after implementation.

The process runs from liabilities and risk tolerance to the policy mix, then benchmarks, then managers and guidelines, then monitoring.

A harder one

A plan's total return variance has a policy benchmark volatility of 11 percent and an active management tracking error of 2 percent, with active returns uncorrelated with the benchmark. The share of total fund return variance attributable to active management is closest to:

  1. 18.2 percentWhy not: Divides the tracking error by the benchmark volatility; this is a ratio of volatilities, not a share of variance.
  2. 3.2 percent - correct
  3. 15.4 percentWhy not: Treats volatilities as additive, 2 / (11 + 2), instead of variances.
  4. 2.0 percentWhy not: Reads the tracking error itself as the percentage of variance.

Total variance = 11² + 2² = 125; active share = 4/125 = 3.2 percent. The policy mix drives most of fund risk; active management is a small part.

The hardest tier

A plan's equity sleeve is run by two active managers, each given 50 percent of the sleeve and each with a tracking error of 2.0 percent against the sleeve benchmark. The correlation of their active returns is 0.3. The sleeve's tracking error is closest to:

  1. 1.61 percent - correct
  2. 2.00 percentWhy not: Averages the two tracking errors, which ignores diversification between the managers.
  3. 1.41 percentWhy not: Assumes the active returns are uncorrelated, which drops the 0.3 correlation term.
  4. 1.18 percentWhy not: Subtracts the correlation term instead of adding it.

TE² = 0.5² x 4 + 0.5² x 4 + 2 x 0.5 x 0.5 x 0.3 x 2 x 2 = 1 + 1 + 0.6 = 2.6, so TE = 1.61. The plan, not the managers, sees this aggregate.

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