CH 15: Choosing an appropriate investment strategy

Question 1

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

3

Answer 1

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

Question 2

Give 4 examples of possible investment objectives for an institutional investor

4

Answer 2

• Meeting liabilities as and when they fall due
• Demonstrating solvency (on an ongoing, statutory and discontinuance basis)
• Minimising the burden on 3rd parties eg. trying to reduce the amount an employer has to contribute to a pension fund by taking aggressive investment strategy
• Maximise returns
• Outperform competitors

Question 3

Give 4 examples of how risk might be defined for an institutional investor.

4,1

Answer 3

1. Standard deviation or volatility of return from an investment. Period,Real/Nom,Currency
2. The probability of ruin (or complete failure of an investment)
3. The probability of failing to achieve the investor’s objectives
4. Not outperforming competitors

• All don’t hold for companies as prob ruin is small from well diversified portfolio and ST variability is not important if invest LT

Question 4

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

3

Answer 4

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

Question 5

List 16 factors that influence the long term investment strategy of an institutional investor

Answer 5

• Size of the assets (absolute / relative)
  Small funds not enough to diversify
  Assets>Liabilities ability to mismatch
• Objectives
• Uncertainty of the liabilities
  Timing and amount. Hugher uncertainty = higher capital held
• Nature of the liabilities
  Real/ Nom, Strategy needs to match liabilities
• Diversification
  Low correlation bet returns of assets = better diversification
• Existing asset portfolio
• Return (expected long term)
• Tax treatment of the assets / investor
  Income and CGT
• 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

A SAD CUTER INVESTOR

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

Factors influence Individual investment strategy

4

Answer 9

• Assets,Liabilities,Matching
• Risk
• Returns from assets
• Other constraints :Investment,risk appetite.practical

Question 10

Individual factors: Assets

3

Answer 10

1. Consists of current wealth and future income
2. Nature of income: Real vs Nom
3. Uncertainty in relation to receipt of income

Question 11

Individual factors: Liabilities

5

Answer 11

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 12

Indivdual factors: Matching

2

Answer 12

• eg retired rely on income from savingsso need to maitain real returns on savings
• eg retiree income should last duration of lifetime

Question 13

IndivIdual factors : Risk

3

Answer 13

• Variability of MV’s: individiual less concerned as solvency does not need to be proved
• Switch to less volatile aseets closer to maturity
• Risk can be reduced by diversification

Question 14

Individual factors: Return from assets

4

Answer 14

• Aim to maximize expected returns after expenses and taxes
• Tax rates vary across individuals and certain products exploit loopholes
• ‘Feel good return’ : charities, PMI, Art
• Subjective factors: owning large tangible assets

Question 15

Individual factors: Other Constraints

3

Answer 15

Investment constraints:
* Excess assets: Ownership depend on size of liabilities
* Uncertainty of income and outgo: Reserve needs to be held for uncertainty

Risk appetite:
* Dependant on financial position ( age,wealth,dependants)

Practical Constraints:
* Not wide investment to achieve diversification
* High expenses for investments
* Lack of info/expertise

Question 16

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

Answer 16

Liquid assets or consider using insurance.

Question 17

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

Answer 17

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.

Question 18

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

Answer 18

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 19

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

Answer 19

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

This is called LIFESTYLING.