15. Choosing an appropriate investment strategy Flashcards
What criteria should an investment objective for an institutional investor satisfy
- Clearly stated
- Quantifiable
- Frame in terms of risk, total retrun and timing of cashflows
Types of objectives an institutional investor aims to meet
TeaM CAMPS
- Tracking an index as closely as possible
- Meeting the liabilities as they fall due
- Controlling the amount and timing of future obligations
- Achieving a pre-specified target level of investment return or funding level
- Matching or exceeding competitors – e.g. the median return or funding level
- Proving that there are sufficient assets available should the provision of future benefits be discontinued
- Satisfying statutory and/or realistic solvency requirements
For an institutional investor, how might risk be defined
- Standard deviation or volatility of return from an investment
- Probability of ruin
- Probability of failing to achieve the investor’s objectives
On what three things does the risk appetite of an institutional investor depend
- Nature of the institution (pension, bank or insurer)
- Legal or statutory controls
- Constraints of its governing body and documentation
Factors affecting the long-term investment strategy of an institutional investor
A SAD CUTER INVESTOR
- Accounting regulations
- Size of assets ( absolute/relative)
- Accrual of future liabilities
- Diversification
- Currency of the liabilities
- Uncertainty of the liabilities
- Tax treatment of the assets/investor
- Environmental/social/governance issues
- Risk appetite
- Institution’s objective
- Nature of the liabilities
- Voluntary and legal restrictions
- Existing asset portfolio
- Solvency requirements
- Term of the liabilities
- Other funds’ strategies (competition)
- Return
Factors affecting the long-term investment strategy of an individual
MERMAIDENN
- Matching the nature, term, currency and uncertainty of the liabilities
- Expenses are relatively high when investing small amounts
- Risk aversion and a dislike of volatility
- Maximising expected return on investments, net of expenses and tax
- low free Assets, which constraint’s ability to mismatch and take risk
- Individual’s tax status and the tax treatment of the asset
- Diversification, to reduce specific risk
- Expertise/ Information lacking relative to institutional investors
- Need for income to live on vs growth for future
- Not enough assets for direct investment in certain assets classes
Why investor may prefer high yielding investments over low yielding?
3
- Currently has high cash outflow requirement and wants to avoid the expense and uncertainty of realizing an asset
- Is not concerned about reinvestment risk
- Pays a higher tax on capital gains than on income
Advantages and Disadvantages of Collective Investment Schemes (CIS) for Personal Investors
6/3
- +diversification
- +access to expensive/unusual investments
- +ease of investment
- +Investment expertise
- +Appropriate for small sums
- +tax advantages
- -relatively high expense due to manager fees
- -funds stated objectives may not materialise perfectly
- -lack of control over chosen investment
When would an overseas market be considered cheap
- E(return in overseas currency) + E(depreciation of home currency) > E(return in home currency)
- The investor should consider investing overseas if the margin of the left-hand side over the right-hand side exceeds the risk margin the investor requires for overseas investment.
When selecting individual assets for a fund, what should the investor consider?
3
- The expected return net of taxes and expenses
- The volatility of returns
- Whether the asset selected has low covariance with other assets in the portfolio. For diversification and therefore reduce specific risk
Why will an institutional investor aim to maximise the investment return
- Competitive reasons – in order to attract new business
- Maximise shareholders returns
- Minimize the cost of providing for the liabilities
What are the characteristics of the liabilities of an individual
- Consist of future spending (including debt repayments)
- Mainly real but not necessarily linked to standard price inflation index
- Mainly denominated in the domestic currency
- Both short-term and long-term liabilities
- Some uncertain in amount and timing
What are the characteristics of the assets of an individual
- Consist of current wealth and future income
- Occupational income=> a real asset
- Pension income=> may be fixed in nature
- Uncertainty in relation to receipt of income=> redundancy or ill health
Since both income and expenditure of individuals may be uncertain, what sort of assets should they consider holding
- Liquid assets
- Insurance
What three factors does a retired individual need to consider in relation to investment strategy
- Generating sufficient income to live on from their assets
- Maintaining that income in real terms
- Allowing for sufficient growth of capital
How can retired individuals generate sufficient income from the assets they own
- Annuities
- High income yielding assets
- Periodic redemption of assets (bonds?)
- Periodic sale of low-income yielding assets
How can the risk of a fall in the market value of individual assets just prior to retirement be avoided
- Suitable investment strategy -switch to less volatile strategy. This is called lifesyling. Eng. Bonds then purchase annuity
