C14 Choosing an investment strategy: Institutions

Question 1

Describe the nature of investment objectives of Institutions

Answer 1

Criteria:
- Clearly-stated
- Quantifiable
- Framed in terms of:
1. Allowable level of risk
2. Total required return
3. Timing of cashflow

Question 2

Examples of investment objectives of Institutions

Answer 2

Examples:
1. Meet liabilities as they fall due
2. Control incidence of obligations on a third party, e.g. ER conts
3. Provide sufficient funds to meet liabilities as they fall due
4. Provide sufficient funds to meet liabilities on discontinuance
5. Achieved a pre-specified target level of investment return or funding
6. Matching or exceeding competitors – eg the median return or funding level
7. Tracking an index as closely as possible
8. Controlling the amount and timing of future obligations
9. Satisfying statutory solvency requirements
10. Demonstrating that there are sufficient assets available should the provision of future benefits be discontinued

Question 3

Definition of risk for an institution

Answer 3

Examples:
1. Standard deviation or variance of return from an investment
2. Probability of ruin (or complete failure of an investment)
3. Probability of failing to achieve the investor’s objectives (eg. underperforming competitors)

Question 4

Considerations in defining investment risk

Answer 4

When defining investment risk, need to consider:
- the time period being considered ( held to redemption or not)
- whether the returns are measured in real (ie net of inflation) or nominal terms.
- the currency in which we measure returns.

Question 5

Factors affecting risk appetite of an institutional

Answer 5

Factors affecting risk appetite of an institutional investor:
1. Nature of institution
2. Constraints of its governing body
3. Legal or statutory controls

Question 6

Factors Influencing Investment Strategy of Institutions

Answer 6

Factors Influencing Investment Strategy of Institutions
UNSORTED CARROTS

1. Uncertainty of Liabilities (Amount and timing)
2. Nature of liabilities (Fixed, real)
3. Size of assets (absolute/relative)
4. Objectives
5. Return (expected long-term)
6. Tax treatment of assets/investor
7. Existing portfolio of assets
8. Diversification need
9. Currency of existing liabilities
10. Accrual of liabilities in the future
11. Restrictions - statutory/legal/voluntary
12. Risk appetite
13. Other funds’ strategies (competition)
14. Term of existing liabilities
15. Solvency requirements/Statutory valuations

Question 7

Preference for High income vs. low income yielding investments by Institutions

Answer 7

An institutional investor may prefer high-income yielding investments if the investor:
1. Has high present cash outflow requirements and wants to avoid expense and uncertainty of realising assets
2. Is not worried about reinvestment risk
3. Pays a higher rate of tax on capital gains than on income
4. Desires less volatile investments (high-income yielding investments have a lower discounted mean term and hence are less volatile) e.g. for solvency demonstration or if the investor has low levels of free assets

Question 8

Factors to consider when selecting individual investment by Institutions

Answer 8

Factors to consider:
1. Expected return net of tax and expenses
2. Volatility of returns
3. Whether asset selected has a low covariance with the other assets in the portfolio => diversification => reduced specific risk

Question 9

Competitive reasons why Institutions will seek to maximise investment returns

Answer 9

For competitive reasons to
1. Attract new business
2. Maximise shareholders’ return
3. Minimise the cost of providing liabilities