Ch 15: Choosing an appropriate investment strategy Flashcards
What criteria should an investment objective for an institutional investor satisfy?
- Clearly stated
- Quantifiable
- Framed in terms of risk, total required return and timing of cashflows
Give 4 examples of possible investment objectives for an institutional investor
- To meet the liabilities as the fall due
- To control the incidence of future obligations on a third party (e.g. employer pension contributions)
- To provide sufficient funds to be able to demonstrate ability to meet the liabilities as they fall due
- To demonstrate that there are sufficient funds to meet the liabilities if discontinuance where to occur.
Give three examples of how risk might be defined for an institutional investor.
- Standard deviation or volatility of return from an investment
- The probability of ruin (or complete failure of an investment)
- The probability of failing to achieve the investor’s objectives
On what 3 things does the risk appetite of an institutional investor depend?
- The nature of the organization
- The constrains of its governing body and documentation
- Legal or statutory controls
List 16 factors that influence the long term investment strategy of an institutional investor
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
Why might an institutional investor prefer high-income yielding investments to low-income yielding investments?
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
When would an overseas market be considered ‘cheap’?
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.
When selecting individual assets for a fund, what three factors should the investor consider?
- The expected return net of tax and expenses.
- The volatility of returns
- Whether the assets selected has a low covariance with the other assets in the portfolio => diversification => reduced specific risk
Why will the investor want to maximize returns subject to constraints?
- For competitive reasons, to continue to attract new business.
- To maximize shareholder returns
- To minimize the cost of providing for the liabilities
Outline the characteristics of the liabilities of an individual
- Consist of future spending (including debt repayments)
- Mainly real, but not necessarily linked to a standard price inflation index
- Mainly dominated in the domestic currency
- Both short term and long term liabilities
- Some uncertainty in amount and / or timing
Outline the characteristics of the assets of an individual
- Consists of current wealth and future income
- Occupational income: a real asset
- Pensioners income: may be fixed in nature
- Uncertainty in relation to receipt of income
Since both the income and expenditure of individuals may be uncertain, what sort of assets should they consider holding?
Liquid assets or consider using insurance.
List 10 factors affecting the long-term investment strategy of an individual.
- Matching the nature, term, currency and uncertainty of the liabilities.
- A need for income to live on vs growth for the future
- Risk aversion and a dislike of volatility
- Diversification, to reduce specific risk
- Maximizing expected return on investments, net of expenses and tax
- The individual’s tax status and the tax treatment of the asset
- Low free assets, which constrain the ability to mismatch and take risks
- Not enough assets for direct investment in certain asset classes
- High relative expenses when investing small amounts.
- Lack of information / expertise relative to institutional investors.
List 3 factors that a retired individual needs 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 to live on from the assets that they own?
- Annuities
- High income yielding assets
- Periodic redemption of assets
- Periodic sale of low income yielding assets
