Ch 15: Choosing An Appropriate Investment Strategy

Question 1

What criteria should an investment objective for an institutional investor satisfy?

Answer 1

1. Clearly stated
2. Quantifiable
3. Framed in terms of risk, total required return and timing of cashflows

Question 2

Give 4 examples of possible investment objectives for an institutional investor

Answer 2

1. To meet the liabilities as the fall due
2. To control the incidence of future obligations on a third party (e.g. employer pension contributions)
3. To provide sufficient funds to be able to demonstrate ability to meet the liabilities as they fall due (can be on statutory or realistic basis).
4. To demonstrate that there are sufficient funds to meet the liabilities if discontinuance where to occur.

Question 3

Give three examples of how risk might be defined for an institutional investor.

Answer 3

1. Standard deviation or volatility of return from an investment (MVPT/CAPM)
2. The probability of ruin (or complete failure of an investment)
3. The probability of failing to achieve the investor’s objectives

Question 4

On what 3 things does the risk appetite of an institutional investor depend?

Answer 4

1. The nature of the organization
2. The CONSTRAINTS of its governing body and documentation
3. Legal or statutory controls

Question 5

List 15 factors that influence the long term investment strategy of an institutional investor

Answer 5

SOUNDER TRACTORS

Size of the assets (absolute / relative)
Objectives
Uncertainty of the liabilities
Nature of the liabilities
Diversification
Existing asset portfolio
Return (expected long term)

Tax treatment of the assets / investor
Restrictions - statutory / legal / voluntary
Accrual of liabilities in the future
Currency of the existing liabilities
Term of the existing liabilities
Other funds’ strategies (competition)
Risk appetite
Solvency requirements and accounting requirements

Question 6

Why might an institutional investor prefer high-income yielding investments to low-income yielding investments?

Answer 6

The investor:
- Currently has high cash outflow requirements and wants to avoid the expense and uncertainty of realizing assets
- is not worried about reinvestment risk
- pays a higher rate of tax on capital gains than on income

Question 7

When would an overseas market be considered ‘cheap’?

Answer 7

An overseas market is considered cheap if:

expected return in local currency + expected depreciation of domestic currency > expected 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 required for overseas investment.

Question 8

When selecting individual assets for a fund, what three factors should the investor consider?

Answer 8

1. The expected return net of tax and expenses.
2. The volatility of returns
3. Whether the assets selected has a low covariance with the other assets in the portfolio => diversification => reduced specific risk

Question 9

Why will the investor want to maximize returns subject to constraints?

Answer 9

1. For competitive reasons, to continue to attract new business.
2. To maximize shareholder returns
3. To minimize the cost of providing for the liabilities

Question 10

Outline the characteristics of the liabilities of an individual

Answer 10

1. Consist of future spending (including debt repayments)
2. Mainly real, but not necessarily linked to a standard price inflation index
3. Mainly dominated in the domestic currency
4. Both short term and long term liabilities
5. Some uncertainty in amount and / or timing

Question 11

Outline the characteristics of the assets of an individual

Answer 11

1. Consists of current wealth and future income
2. Occupational income: a real asset
3. Pensioners income: may be fixed in nature
4. Uncertainty in relation to receipt of income

Question 12

Since both the income and expenditure of individuals may be uncertain, what sort of assets should they consider holding?

Answer 12

Liquid assets or consider using insurance.

Question 13

List 10 factors affecting the long-term investment strategy of an individual.

Answer 13

1. Matching the nature, term, currency and uncertainty of the liabilities.
2. A need for income to live on vs growth for the future
3. Risk aversion and a dislike of volatility
4. Diversification, to reduce specific risk
5. Maximizing expected return on investments, net of expenses and tax
6. The individual’s tax status and the tax treatment of the asset
7. Low free assets, which constrain the ability to mismatch and take risks
8. Not enough assets for direct investment in certain asset classes
9. High relative expenses when investing small amounts.
10. Lack of information / expertise relative to institutional investors.

(SOUNDER TRACTORS again, without E (now expenses), A, O2, S2)

Question 14

List 3 factors that a retired individual needs to consider in relation to investment strategy

Answer 14

1. Generating sufficient income to live on from their assets
2. Maintaining that income in real terms
3. Allowing for sufficient growth of capital

Question 15

How can retired individuals generate sufficient income to live on from the assets that they own?

Answer 15

1. Annuities
2. High income yielding assets
3. Periodic redemption of assets
4. Periodic sale of low income yielding assets

Question 16

How can the risk of a fall in the market values of an individual’s assets just before retirement be avoided?

Answer 16

A suitable strategy is often to switch to less volatile assets as the time of retirement approaches.

This is called LIFESTYLING.

Question 17

4 Definitions of Risk

Answer 17

• probability of default
• expected variability of return
• risk of underperforming compared with competitors
• probability of failing to achieve the investor’s objectives.

Question 18

Relative performance risk

Answer 18

The risk of under performing ones competitors

Question 19

4 Groups of people who decide on the risk tolerance of an institution

Answer 19

• trustees (of trusts)
• members (of DC pension funds)
• directors (of companies)
• donators (of charities)

Question 20

4 Common problems of switching large portfolios

Answer 20

• Shifting market prices
• Timing issues
• Dealing costs
• Capital Gains Tax liability crystallizes

Question 21

3 Aspects to consider when defining investment risk

Answer 21

1. The time period being considered.
2. Are returns measured REAL or NOMINAL terms?
3. The currency in which returns are measured