2. Types of investors and their objectives (Week 2) Flashcards
65 years old retiree
- Single, no children, healthy and active
- Live a comfortable lifestyle
- Renting, no mortgage, no credit card debt
- Only asset is $5 million cash in deposit account with NAB
what are the risks?
- unlikely to have high inflation to erode wealth.
- bankrupty of NAB
-
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
Investor circumstances
Business or personal considerations
receive company shares as part of bonus or incentive
tied up with same company .
diversify away from your company
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
Investor circumstances
reference portfolios
relevant for portfolio managers
benchmark to evaluate portfolio manager’s performance. Risk averse as portfolio managers. not too different from industry norm.
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
Investor circumstances
•need for liquidity or ‘immediacy’
need cash from their fund
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
Investor circumstances
- need for liquidity or ‘immediacy’
- costs – management fees, transaction costs, taxation, etc
- reference portfolios – legacy portfolio; ‘background’ assets like human capital, residential property
- business or personal considerations, e.g. career
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
•holding period vs. review period why?
Investor circumstances
Regularly review of portfolio performance give you chance to new changes of life and investment opportunities.
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
•holding period vs. review period
Investor circumstances
Holding period = entire investment horizon . 30-40 years of investment horizon
Review period = regularly check portfolio performance over certain period
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
Investor circumstances
- holding period (entire investment horizon) vs. review period
- dynamics, i.e. investing over more than just one period
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
Investor circumstances
Will continue until we do not need funds from superannuation
can be indefinite e.g. family trust. providing trust flow for future generations
Ways in which investors can differ
Objectives
Risk preferences
Investment horizon
Investor circumstances
Australian pension funds have
offered Defined benefit funds to defined contribution funds in the last 20 years
DB funds calculation
e.g. uni super
based on age
years of service
how much you’ve contributed
your salary over 5 years
Defined contribution Funds
features
make regular contribution. manage asset allocation in super account by yourself
when you retire, take what is in super account.
DB Fund
Risk
Chance the fund is not able to meet liability payment
value of total assets and value of liabilities. Difference measures the risk. Larger the difference, fund is in deficit and in trouble
DB Fund Objective
meet liability
benefits payout obligation for retiring members
investment horizon is indefinite
DC Funds Objective
Some may want to use it to payout their mortgage when they retire
set up family trust to benefit future generations
set up retirement living
How do portfolio managers manage DC Funds
Given benchmark. I invest in High growth in diversified portfolio product.
This portfolio manager will be given a benchment e.g.
Average performance of all of the high growth superannuation funds in Australia.
How do portfolio managers manage DB Fund
manage the gap
asset allocation decision: improve situation of fund. If there is deficit, try to reduce the deficit.
insurance companies
Put collected premium and put in investment fund
objective
Meet policy holders. Meeting liabilities
generate return as profit. impact of profit
Endowments & Foundations
Objectievs
certain programs to support e.g upgrade IT system, build library.
That will depend on income. Return greater than long term inflation
Fund managers
objective
e.g. retail mutual funds, colonial first state
concerned with profit of the fund and concern of the relative performance e.g. published by morning star and internal ranking of their performance. Under constant pressure to outperform.
Private investors incl SMSF
Objective
Risk
•
•70-year old retired surgeon
–Self-funded retiree
–Own house (paid off)
–Live a very comfortable lifestyle ($65,000/year)
–Superannuation $5 million
Other assets $15 million
is 5m enough for them to live with for the rest of their life
Not able to finance him the rest of his life
Private investors incl SMSF
Objective
Risk
•70-year old retiree
–Government pension
–Renting
–Live a modest lifestyle ($20,000/year)
–Total assets of $20,000 cash from inheritance
–Need $1,000 cash every year for a chronicle disease treatment
Generate 5% return P.a
Not being able to fund that
Definition Risk
- Risk as the possibility of an adverse outcome
- An adverse outcome as failure to meet objectives
Corporate Super DB Fund
Objective
Investment horizon
meet the benefits payment requirement (liability) of its members
•on-going, indefinite
Corporate Super DB Fund
difference from DB Fund
Profit target for managers, executives and board of directors
anything you take from the pocket of shareholders will go to DB Fund to form part of assets.
Corporate Super DB Fund
asset allocation decision
member
produce a perfect match
just need to be paid retirement funds
Corporate Super DB Fund
asset allocation decision
Executives
Board of DB Fund, they have own performance pressure e.g. total shareholder return, profitability target
Corporate Super DB Fund
asset allocation decision
sponsoring entity(the company)
Push for higher asset allocation to growth assets = higher expected returns, higher expected future incomes and higher chance of meeting future liability of the fund
BUT HAVE TO CONSIDER
higher volatility between assets and liability. high deficit. High difference between asset and liability. Another GFC, huge deficit b/c of asset allocation of 80% growth assets
Corporate Super DB Fund
asset allocation decision
is the outcome of “negotiations” among all stakeholder who have distinct objectives.
üSponsoring entity (the company)
üMembers
üPortfolio managers
üGovernment
Corporate Super DB Fund
members
Employees, union, company management eg CEO, members of DB Fund
Corporate Super DB Fund
Risk is defined by
difference between value of assets and value of estimated benefits Net PV of future benefits payout
that is for the fund
What is the asset allocation decision
To predict to relevant risk
e.g. allocating asset risk to manage the risk. higher chance of achieving objectives
the essence of investment management is the management of risk, not management of returns
how to measure risk for objective
Others - regret
probability of wrong choice
how to measure risk for objective
Relative Benchmark aka peer risk
Tracking error. How much you deviate from industry norm of asset allocation
200 index as benchmark. your asset allocation decision will help you meet that benchmark or perform as well.
Sometimes portfolio managers will take additional risk by allocating assets away from benchmark.
if there is 25% asset allocation with ASX 200 in banking sector, if you are embarrassed with banking sector given recent renovation by banking commission and want to allocate in portfolio of 20% or 15% in banking sector in your own portfolio.
Generating substantial peer risk. Other portfolio managers in the industry are allocation 25% and you are allocation 15%. if you are right
how to measure risk for objective
Absolute target return
objective by fund manager
e.g. 3% excess return above inflation using inflation as benchmark or 1% above australian equity funds in the market. difference of portfolio performance and benchmark will be the risk measure
Shortfall
how to measure risk for objective
Suppot spending programs for endowment funds
Shortfall
difference between desired spending and income generated by endowment funds
how to measure risk for objective
Consumption in retirement
Shortfall
difference between desired consumption and available superannuation income stream
how to measure risk for objective
Profit impact
profit volatility
any contribution made by sponsoring entities for company is taken from the profit available for distrubition to shareholders
how to measure risk for objective
Meeting liabilities
surplus volatility/shortfall
how to measure risk for objective
Maximize E[U(W)]
Maximise utility of wealth
•Asset/portfolio volatility (drops)
especially the downside
Issues with quantitative risk measures
Characterising the distribution
parametic vs non-parametric
We do both to have better understanding of risk
parametic (Model-based) have certain assumptions that return follows certain assumptions e.g. standard deviation.
vs
non-parametric (Data-based)
- don’t care about distribution of returns; only focus on data i have. Calculate the probability of loss. don’t care about Z score or confidence interval. don’t assume they follow assumptions
- rely on data, over different period, different numbers of quantitaitve measures of risk eg probability of loss
Issues with quantitative risk measures
•Matters that cannot be easily incorporated
Personal
personal assets .g. human capital, family home
difficult to quantify or assess
Issues with quantitative risk measures
•Matters that cannot be easily incorporated
Funding or
funding or cash flow uncertainty and illiquidity risk
- Funding or cash flow uncertainty
DB Funds, endowment or charity funds e.g. major blow of contribution. have to change their asset allocation to meet the expected expenditure. have to deal with other damages of the risk associated with the funds.
Issues with quantitative risk measures
•Matters that cannot be easily incorporated
Risks
–Business risk (bankrupty risk), personnel risk, counterparty risk, governance-related failures, changes in public policy
- very hard to forecast these
Issues with quantitative risk measures
•Matters that cannot be easily incorporated
black swans
possibilities in extreme markets (‘black swans’)
e.g. cannot predict GFC on australian economy
cannot be incorporated into quantitative measures of risk. rare to forecast another GFC
Issues with quantitative risk measures
•Characterizing the distribution
- Investment horizon
- investment horizon is monthly v 10 years
short long term horizon:
- sell portfolio after 1 month
- bear loss in short period. within a month, more likely to experience momentum. and unlikely to have mean reversion
- very volatile goes negative
every month calculate portfolio returns for past 10 years. any loss i made in early years are recouped.
long term mean reversion: asset returns convert to their long term mean. expected return of assets is positive
Issues with quantitative risk measures
•Characterizing the distribution
- Instability in return generating process
using recent and old data
early 1980s - all the regime of monetary policy into quantitative analysis and part of it will distort risk analysis e.g. volatility. Might include something irrelevant for future
Try to include recent period: using most recent, lose data points. Yearly data interval, past 10 years, have 10 data points. difficult to run quantitative analysis
Issues with quantitative risk measures
•Characterizing the distribution
–Instability in return generating process
structural change in early 1990s. double digit mortgage
Fundamental risk approach
- Any factor to which the overall portfolio is exposed
- Also consider: liabilities, illiquidity, home bias, systemic risks
Fundamental risk approach
Economic risk
all assets you hold in australia is subject to economic risk
Characteristics of illiquidity risk
- Illiquid assets typically cost more to transact – result in an ugly “haircut”
- Illiquidity can result in a failure to transact – result in an undesired “perm”
“haircut”: sell for big discount to attract buyers, end up with an ugly haircut.
“perm”: can’t transact, stuck with what you have, end up with perm;
- True asset value is often unknown
- Historical performance may be misleading
- Illiquidity risk is systematic; liquidity can be absent when most needed - like taxi in a storm
Characteristics of Illiquidity
•Illiquidity has investor-specific implications
− time horizon
−need for immediacy
−tolerance for sub-optimal portfolio
−discretion over sale
Illiquidity Risk Management
Managing Illiquidity Risk – Evaluation
Region
- Trading necessary and infeasible
Sub-optimal portfolio unavoidable
Potential dire consequences, e.g. business survival
Illiquidity Risk Management
Managing Illiquidity Risk – Evaluation
Region
- Trading necessary and feasible
Cost of transacting unavoidable, and open-ended
Risk compounded if trading is more likely to become mandatory when it is most costly
Illiquidity Risk Management
Managing Illiquidity Risk – Evaluation
Region
- Trading desirable and feasible, but costly
Implication
Investor has the option to trade
Effective cost reflects minimum of:
- Cost of transacting
- Cost of persisting with sub-optimal portfolio
Illiquidity Risk Management
•“Risk Management Cycle”
–Understand the context
–Identify the risks
–Evaluate the risks
–Address the risks
–Monitor the portfolio
Illiquidity Risk Management
•Illiquidity risk is complex to analyze, but it doesn’t mean that investors should avoid illiquid assets altogether because illiquid assets do provide diversification benefits and additional source of returns to portfolio
the reference portfolio
benchmark for performance evaluation
Relative Risk: peer risk and regret
Example: The reference portfolio (benchmark for performance evaluation): a balanced portfolio of 60% equity and 40% bond. Within the equity bucket, 50-50 for domestic vs world equity.
Portfolio manager’s decision on the allocation of funds into domestic and world equity plays an important role in the portfolio performance over different investment horizons.
The average performance difference is -5% for the period before 2000, 5% for the period after 2000. Long term average is very close to zero.
Liability-driven Investment Management
•Strategies
–Strategic and dynamic asset allocation
–Derivatives
–Special purpose vehicles
–Annuity contracts
–Reinsurance
–Managing liabilities
Liability-driven Investment Management
••Emerging risks
–Longevity risk, inflation risk, operational risk, legislative risk
Liability-driven Investment Management
•Immediate risks
–Interest rate risk, market risk, assumption risk
Which of the following statements about illiquidity is correct?
Illiquidity risk is idiosyncratic; i.e. a systematic risk that requires compensation for bearing such a risk
- non-diversifiable. depends on investor time horizon
Which of the following statements best describe the risks for a 65 years old retiree with $1 millin cash in savings account as the only financial resource for her retirement?
A
ASX 200 index volatility.
B
The looming property market slump in major Australian cities, such as Sydney and Melbourn.
C
Interest rate risk, ie. the possiblity of the Reserve Bank of Australia lowering target interest rate given the current challenges in the economy. This would put downward pressure on the interst rate in the retail market. There’s a chance that the income from her savings account is not enough to support her retirement.
D
The possiblity of bankrupcy of the bank where she holds her savings account. If this happen, she would have to suffer from substantial financial loss and the recovered amount would not be enough to support her retirement.
E
The possiblity that the savings account is in shortfall to support her desired lifestyle in retirement.
C
Interest rate risk, ie. the possiblity of the Reserve Bank of Australia lowering target interest rate given the current challenges in the economy. This would put downward pressure on the interst rate in the retail market. There’s a chance that the income from her savings account is not enough to support her retirement.
D
The possiblity of bankrupcy of the bank where she holds her savings account. If this happen, she would have to suffer from substantial financial loss and the recovered amount would not be enough to support her retirement.
E
The possiblity that the savings account is in shortfall to support her desired lifestyle in retirement.
Select all of the correct statements about “risk” in fund management.
A
Risk is simply measured as the standard deviation of returns for any portfolios.
B
Risk is linked to investor’s objectives.
C
Risk is linked to investment horizon, eg. the standard deviation of unlisted property fund tends to understate the true risk over short run.
D
Risk is the undesired outcome that investor’s objective is not achieved.
E
All risks can be quantified using statistical measures.
B
Risk is linked to investor’s objectives.
C
Risk is linked to investment horizon, eg. the standard deviation of unlisted property fund tends to understate the true risk over short run.
D
Risk is the undesired outcome that investor’s objective is not achieved.
Which of the following funds have the primary objective as meeting liabilities?
A
A direct property fund with a leverage ratio of 80%
B
A defined benefit superannuation fund
C
A SMSF of a 35 years old bank employee
D
A defined contribution superannuation fund
E
An endowment fund of a university
A defined benefit superannuation fund
Which of the following investors is most likely to be concerned about peer risk or tracking error risk?
Fund manager of a retail Australian equity fund
Why is DB Fund and Investment company not concerened about peer risk or tracking error risk?
B
Insurance company. Every insurance fund have their own particular position of liability
Genreate wealth to maximise wealth of company but DB funds do not have
No benchmark. Each DB fund is special. It is in its own position of expected forecasted liability
DC funds have a
benchmark portfolio to assess their performance or given an absolute return.
how do DC funds have shortfall?
shortfall = difference between portfolio return and benchmark
within uni super lots of products, balanced portfolio within accumulated division, may be given absolute return e.g. 3% above long term inflation, sometimes 6%.
DC funds concerned with skewness b/c
skewness indicates downside risk. concerned with the tail risk. skewness of total portfolio return.
How does shifting to 5-years change the risk measures?
Distribution of rate of (per annum) returns narrows (SD reduces from 14.6% annually to 6.2% over 5 years), and so does the probability of lower returns (reduces from 17.6% annually to 5.9% over 5 years)
Another important issue involves whether to manage the fund’s asset class investments passively or actively.
Active management
what must you consider
The higher expected returns of active management must be weighed against the associated additional risk and incremental cost
Another important issue involves whether to manage the fund’s asset class investments passively or actively.
Active management
attempt to exceed the performance of a given index
Another important issue involves whether to manage the fund’s asset class investments passively or actively.
Passive management
You can choose either to seek to match the performance of a given index
The S&P/ASX300 index alone is capable of explaining about
adding world equity
82% of the fluctuation in returns.
Adding world equities allows nearly 93% of variation to be explained.
why is a typical balanced portfolio of 60 growth and 40 other assets poorly diversified
such portfolios are invested in only a subset of all assets in the economy.
About 85%-90% is held in financial assets (equities, listed property, fixed income, and similar assets within other investments such as hedge funds). Nearly 60% of assets reside in Australia.
Why are such concentrated exposures observed in these portfolios? (financial assets and home bias)
Pursuit of returns
when investors desire higher returns, a typical response is to go for the ‘equity risk premium’. This motivates the high equity weightings in many portfolios.
Why are such concentrated exposures observed in these portfolios? (financial assets and home bias)
Availability
The prevalence of listed equities and fixed income within portfolios occurs in part because they are very accessible, particularly relative to other assets in the economy
Why are such concentrated exposures observed in these portfolios? (financial assets and home bias)
Liquidity
Liquidity – Many investors, most notably institutions, require a certain degree of liquidity to support portfolio rebalancing, asset valuation and redemption needs. Financial assets offer this liquidity.
Long term investor will be concerned with
developments that might lead to an extended episode of poor returns,
Such episodes are usually associated with major fundamental events: The influence of two world wars, the debt-deflationary Depression years, the stagflation in the 1970s, and ‘valuation mean reversion’ after the tech bubble are all highlighted.
A short-term investor sensitive to
A short-term investor sensitive to short-term fluctuations, threat of margin calls, etc might be concerned with the impact of large monthly movements in their portfolio.
For them, risk relates to any event that can cause a large decline in a short period of time.
potential fundamental risks
Macroeconomic risks
Illiquidity
Risks of a structural or systemic nature
Home bias
The relevance of this risk partly depends on time horizon. Why?
Episodes of heightened risk premiums typically play out over periods of less than a year, before confidence returns and markets revert.
Home bias
concentrated exposures in local assets.
Portfolios that are heavily invested in local assets are exposed to
the risk of ructions in one’s own country.
Liability-Driven Investment (LDI) seek to manage the
volatility in the gap between the assets and liabilities of the fund.
what can increase the gap between the gap between the assets and liabilities
changes in key parameters, such as interest rates, inflation or taxation can have a different impact on the present value of those assets and liabilities
LDI-style strategies have been used by super entities where
entity is responsible for delivering defined benefits, particularly pensions, from a dedicated pool of assets.
Individual benefits from DB funds typically depend on
on the member’s salaries near their date of leaving, their completed membership at that date and their reason for leaving
cannot be known in advance.
The investment portfolio of the superannuation fund represents a pool of assets set aside to
pay these benefits when they fall due. The amount in the pool of assets at any time is determined by the level of contributions and investment income
immediate risk - significant short term impact
Why is interest rate a risk in db dunds
will change the present value of the liabilities by causing the discount rate to change, and also that it will change the value of any fixed interest investments held in the portfolio.
immediate risk - significant short term impact
why is market risk a risk for DB funds
risk of movements in investment markets (in particular equity markets). Movements in investment markets will affect asset values, but may also affect benefit liabilities
Emerging Risks Emerging risks have the potential to have financial impact over time
Describe Inflation risk as an emerging risk
the risk that inflation is higher than assumed. This can be either wage inflation (in the case of estimating the defined benefit) or price inflation (in the case of pension obligations)
Emerging Risks Emerging risks have the potential to have financial impact over time
Describe Legislative risk as an emerging risk
government changes legislation in a way that adversely impacts on the pension obligations
risk of tax changes
Emerging Risks Emerging risks have the potential to have financial impact over time
Describe longevity as an emerging risk
Longevity risk - more payments need to be made
partial immunisation form of LDI
trustee decides to dampen, but not fully hedge, the effects of the volatility of assets and/or liabilities.
For example, it is currently quite common for funds to use swaps and other derivatives to hedge the interest rate risk in their asset portfolio to match their liabilities, whilst leaving the majority of their assets in a return-seeking portfolio.
chosen where the costs of a full hedging (immunisation) programme are deemed to be too expensive
Full immunisation is the classic form of LDI in which movements
downside
relatively expensive, in that assets dedicated to precise matching of liabilities are likely to be lower yielding (albeit with lower risk) than would be possible in a more broadly diversified portfolio.
Full immunisation is the classic form of LDI in which movements
movements in the value of the liabilities are precisely offset by simultaneous changes in the value of the assets.
DB v DC
Fees
DC plan: participants pay the investment fees and expenses
DB plan: employer pays
DB v DC
Benefits promised
In DC, no employee is promised a stream of benefits or is assured of accumulating sufficient assets t retirement
DB v DC
Type of fund DB
DB fund, there is a pooled pension fund
employees make contributions to their own accounts and invest in the varous investment vehicles on the platform. Employers run the platform for the employees
What do DB Funds promise employees
that they will receive payments determined by their years of service and salary
objective of DB Funds
sufficient return to cover projected liabilities
How should DB Funds risk be assessed
plan’s surplus/deficit of assets versus liabilities
In general, higher perceived wealth
translates into higher risk tolerance
particularly when they primarily acquired wealth from investment returns –> overconfidence in investment skills —> inappropriately tolerant of risk
Impact of life cycle stage on an individual’s objectives and financial resources
Spending phase
reliance on investment income and assets to cover expenses –> diminished ability to accept risk
Impact of life cycle stage on an individual’s objectives and financial resources
Consolidation phase
Middle to late stages of their careers, most individuals are earnings more than enough to cover expenses, financial wealth is building
investment horizon shortens, diminishing the ability to take risk
Impact of life cycle stage on an individual’s objectives and financial resources
Accumulation phase
individual has long horizon and growing income, but financial net worth is typcialy small relative to liabilities and future needs
due to long horizon and earning potential, such individuals can take significant investment risk with funds not allocated to specific short-term goals
higher wealth and longer investment horizon indicate
greater ability to take risk
Why is liquidity a constraint to an individual’s objective?
individuals need highly liquid assets sufficient to meet normal living expenses in the near term plus emergency reserve equal to 3-12 months
Why is liquidity a constraint to an individual’s objective?
individuals need highly liquid assets sufficient to meet normal living expenses in the near term plus emergency reserve equal to 3-12 months
