4.1 Types of Asset Owners

Question 1

Endowments are set up by NOs for the purpose of raising funds to ____.
Example: University endowment fund.
Foundations are similar from what perspective? But how do they differ?

Answer 1

Endowments are set up by nonprofit organizations for the purpose of raising funds to support specific activities
Foundations are similar from an operational perspective (e.g., provide scholarships), but they differ as they must spend a minimum amount of money each year to maintain their tax-advantaged status (in the US).

Question 2

Identify the four types of pension funds:
1. NPFs
2. PDB
3. PDC
4. IMRA

Answer 2

1. national pension funds
2. private defined benefit
3. private defined contribution
4. individually managed retirement accounts

Question 3

For defined benefit PFs
1. benefits are ____ based on ____ or ____
2. may be ___ and paid to ____
3. size and time horizon vs national PF

Answer 3

1. benefits are known (defined) and computed based on things like salary or years of service
2. benefits may be indexed for inflation and may allow for payments to be made to the surviving spouse
3. funds are usually large, but smaller and shorter in time horizon than national pension funds - alternative investments are likely

Question 4

DC PFs:
1. what is defined? individual accounts?
2. who determines range of investments and allocation?
3. size vs DB/NPF? scope of investments? more common to include ?

Answer 4

1. contributions by the plan sponsor, each beneficiary has an account within the plan
2. plan sponsor determines the range of investments available and then the beneficiary decides how much to allocate to each investment
3. size is smaller than DB and national plans, and range of investments available is likely lower, and includes less alternatives. More common are real estate and liquid alternatives

Question 5

Due to tax benefits associated with individually managed retirement accounts, what is restricted/excluded?

Answer 5

The range of permissible investments is restricted and often private alternative investments are excluded.

Question 6

SWFs are used by national governments to maintain IE —a portion of current funds generated in the country are taken from the current generation and set aside for the benefit of subsequent generations.

Answer 6

SWFs are used by national governments to maintain intergenerational equity—a portion of current funds generated in the country are taken from the current generation and set aside for the benefit of subsequent generations

Question 7

Strategic vs tactical asset allocation?

Answer 7

SAA takes a long-term perspective in optimizing both return and risk. Once SAA is established, tactical asset allocation (TAA) can build on SAA

Question 8

How do you think about future risk and return observations for asset classes?

Answer 8

As a starting point, the idea is to take past risk and return observations and assume that under similar future economic conditions, the same observations will persist and can be projected in the future. However, any known or expected long-term changes would require adjustments to the projections.

Question 9

Expected return formula (RF, inflation etc).

Answer 9

expected return = short-term real riskless rate + expected inflation + risk premium

Question 10

What are three key reasons for risk and return estimation challenges for asset classes?
1. time horizon
2. alpha
3. new

Answer 10

1. while some asset classes have long histories (commodities, real estate), others (PE, HFs) have much shorter, so less data to use
2. in the past, alpha may have accounted for a large portion of past returns, but with increased participation in alternative assets by investors, the amount of alpha will diminish going forward
3. new alternatives are likely to emerge which obviously have no historical track record

Also - for some alternative investments, due to lack of information, it is impossible to accurately estimate risk premiums and correlations between asset classes because significant (and possibly inaccurate) assumptions are made. Other times, there may not be any availability of a specific alternative asset when an asset allocation is being determined for a given portfolio

Question 11

What are typical caps and floors for asset allocations.

Answer 11

Vary - may start at 5% and cap at 30%, but some investors will exceed based on risk tolerance.

Question 12

What are three things that affect allocation % for an investor?
1. absolute
2. relative
3. liquidity

Answer 12

1. absolute allocation size - too small and may not be able to afford a dedicated team/not possible from a cost-benefit perspective, too big and there may not be enough (good) investments
2. relative allocation size - too small and will have negligible impact on portfolio, too big and there is concentration risk
3. liquidity needs - may need liquidity and therefore allocate less to illiquid assets

Question 13

What are three internal constraints within an investment policy?
1. L
2. TH
3. L

Answer 13

1. liquidity - cash outflows in near future, minimum requirements for liquidity etc.
2. time horizon - linked to liquidity and risk, short horizons usually mean less risk due to less time being available to recoup any potential losses
3. limits (sector, country) - some investors have self imposed restrictions, such as ESG, some national PFs are not able to invest in certain countries. Note: it is useful to show investors via simulated portfolio what returns would have been without these restrictions to better understands opportunity cost

Question 14

Two types of external constraints on an investment policy?
1. T
2. R

Answer 14

1. tax status - with many institutions (endowments/foundations, national PFs) not being subject to tax, allocations to tax-exempt investments would be zero. Conversely, for clients who are taxed heavily (e.g., family offices), tax-minimization techniques could involve constraints that require the sale of assets with unrealized losses to reduce the tax impact of realized gains from the sale of other assets
2. regulation - pension funds often face limits on investment allocations in specific asset classes to avoid concentration risk