Chapter 14-Choose an appropriate investment strategy

Question 1

1. Describe the nature of investment objectives.

Answer 1

Investment objectives should be clearly stated, and quantified where possible. Since it is often generally necessary and appropriate to invest in risky assets, the objectives must be framed in such a way as to encompass the allowable degree of risk as well as the required total return and cashflow timing.
The objectives can be described in various ways. One is to meet the liabilities as they fall due. Alternatively, the objective could be to control the incidence of future obligations on a third party (for example, the employer’s contribution rate to a pension scheme). The concept of meeting the liabilities becomes more complex if liabilities continue to accrue (for example a life fund which is still writing business or a pension scheme open to future accrual).
For a continuing entity meeting the liabilities as they fall due and proving that there are sufficient resources to do so are separate objectives, both of which have to be met. There may also be a need to demonstrate that there are sufficient assets available, should the provision of future benefits be discontinued.

Question 2

2. Discuss the use of the word ‘risk’ in investment management.

Answer 2

The word ‘risk’ has many different meanings in investment management. It can be used to describe the probability of an investment failing completely. More frequently it is used to signify the expected variability of the return from an investment.
From a business point of view neither definition is entirely satisfactory. The probability of complete ruin from a well-diversified portfolio of securities is small. The short-term variability in the market value of a portfolio is also of little relevance to many institutions, where the value of liabilities changes in line with the value of assets.

Question 3

3. Set out a practical definition of risk.

Answer 3

The most practical definition of risk is the probability of failing to achieve the investor’s objective. However, it must be recognised that investors are subject to many different risks. For many institutions the risk of underperforming compared with their competitors is one of the most pressing day-to-day risks.

Question 4

4. What factors will influence the risk appetite of an institution?

Answer 4

The risk appetite of an institution will depend on the nature of the institution and on the constraints of its governing body and documentation together with legal or statutory controls.

Question 5

5. List 17 factors that influence the investment strategy of a financial institution.

Answer 5

The principal aim of an investing institution is to meet its liabilities as they fall due. The overriding need is to minimise risk.
The main factors that will influence a long-term investment strategy are:
1. the nature of the existing liabilities - are they fixed in monetary terms, real or varying in some other way?
2. the currency of the existing liabilities
3. the term of the existing liabilities
4. the level of uncertainty of the existing liabilities - both in amount and timing
5. tax - both the tax treatment of different investments and the tax position of the investor need to be considered
6. statutory, legal or voluntary restrictions on how the fund may invest
7. the size of the assets, both in relation to the liabilities and in absolute terms
8. the expected long-term return from various asset classes
9. accounting rules
10. statutory valuation and solvency requirements
11. future accrual of liabilities
12. the existing asset portfolio
13. the strategy followed by other funds
14. the institution’s risk appetite
15. the institution’s objectives
16. the need for diversification
17. environmental, social and governance (ESG) considerations.

Question 6

6. What features of their liabilities should institutions be aware of when determining their long-term investment strategy?

Answer 6

Institutions need to be aware of the long-term investment strategy which will most closely match their liabilities by nature, currency and term. Even if they do not, or cannot adopt such a strategy, other strategies should be evaluated against this benchmark.
The uncertainty of the liability outgo, both in timing and amount, needs to be considered. Institutions with uncertain liabilities will need to have higher liquidity buffers.

Question 7

7. Explain how an investor’s cashflow requirements may influence their choice of investments.

Answer 7

Investors who have low present cashflow requirements may prefer low income yielding investments to avoid the expense and uncertainty of reinvesting income. Conversely investors who need current income may prefer high income yielding investments to avoid the expense and uncertainty of realising assets.

Question 8

8. What does the investor need to allow for in order to maximise returns in their domestic currency?

Answer 8

For an investor wanting to maximise returns in their domestic currency, it is also necessary to allow for the expected changes in the currencies over the period of the investment.

Question 9

9. Explain how an overseas market would be considered cheap compared to the domestic market.

Answer 9

An overseas market would be considered cheap if:
expected return in local currency + expected depreciation of home 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 requires for overseas investment.

Question 10

10. Institutions may also need a strategy that will continue to satisfy the demands of which organisation?

Answer 10

Institutions may also need a strategy that will continue to satisfy the requirements of regulators.

Question 11

11. What factors govern investors’ preferences for income or capital gains?

Answer 11

Investors’ preferences for income or capital growth from their investments are governed by two main factors: tax and cashflow requirements. If an institution is subject to different taxation bases on income and capital gains it will prefer to receive as much of its total return as possible in the lower taxed form.

Question 12

12. For which long-term institutional investors will fluctuating asset market values be a particular concern?

Answer 12

For some long-term institutional investors, fluctuations in asset market values are not of much concern, particularly if the strategy is to hold assets to maturity. However, they may be important for institutions that are required to demonstrate solvency on a regular market value basis and have a low level of free assets. Fluctuating asset values are also, in general, disliked by retail customers of some institutions.

Question 13

13. Explain why institutional investors incorporate environmental, social and governance (ESG) considerations into their investment practices, giving examples of ESG factors that would be considered.

Answer 13

It is increasingly common for institutional investors to incorporate environmental, social and governance (ESG) considerations into their investment practices, with a shift away from considering ESG factors for ethical reasons towards considering them for financial reasons. A
very wide range of investment considerations is included within the scope of ESG. Examples of ESG factors include:
* environmental (climate change, resource depletion, waste … )
* social (human rights, modem slavery, working conditions … )
* governance (bribery and corruption, executive pay, board diversity and structure).

Question 14

14. What factors must be considered when selecting individual investments?

Answer 14

When selecting individual investments, the important factor for an institution is the effect that the investment will have on the performance of the total portfolio. Thus not only are after-tax expected return and variability of the return important, but so is the covariance of that return with the rest of the portfolio. Investments that have a low covariance with the rest of the portfolio represent diversification and will reduce overall risk.

Question 15

15. Outline the three competitive reasons why an institution will seek to maximise investment return.

Answer 15

• for competitive reasons, in order to continue to attract new business
• to maximise shareholders’ returns
• to minimise the cost of providing for the liabilities.

Question 16

16. How do the factors to be considered by an individual when choosing an investment strategy differ from those considered by an institution?

Answer 16

The main factors to be considered by an individual do not differ greatly from those that should be considered by an institution. However the balance between the factors and the details do differ.

Question 17

17. What are the main components of an individual investor’s assets and liabilities?

Answer 17

An individual’s assets consist of current wealth and future income.
Liabilities consist of future spending, including any debt repayments.
Both the term and nature of future spending will need to be considered as well as the expected level.

Question 18

18. What factors will most individuals take some account of when planning their investments?

Answer 18

The sophistication of the planning process used by individuals will vary greatly, but most will take some account of the pattern of their expected future income and major likely expenditure, such as a house purchase, in making their plans.

Question 19

19. Describe the nature. currency and certainty of an individual’s liabilities.

Answer 19

Most of an individual’s liabilities will be real in nature, although the relevant index measure may not be any particular inflation index. Occupational income can be considered as a real income stream, but pensioners may be on a largely fixed income.
Because liabilities will generally be real, assets for long-term investment should usually be real although monetary assets may be chosen for short-term investments, diversification, because the individual is risk averse or because they appear good value.
Most investors will have liabilities and hence want assets in their domestic currency. Investors can still obtain exposure to other currencies and overseas markets through investment funds and overseas earnings from domestic companies. There may be special reasons for holding investments denominated in other currencies, such as incentive and performance schemes for senior employees of companies owned by overseas companies.

Question 20

20. How will individuals’ cashflow requirements influence their investment choice?

Answer 20

Many individual investors, particularly the retired, rely on the income from their investments for their basic lifestyle needs. In this situation it is necessary to find a strategy which will provide a high enough current income while allowing for sufficient growth of capital and income to maintain the level of income in real terms.
Income can be provided by regular redemptions or periodically selling part of a low income yielding portfolio.
A different situation is faced by investors who are investing for the long term, and don’t require a current income from their investments, possibly because they are still working. They will be concerned with reinvestment of income and maturity proceeds but, in general, are freer to concentrate on maximising total return.

Question 21

21. Discuss how volatility influences individuals’ investment choices.

Answer 21

Individuals investing for the long term may not be concerned about short-term variations in the market value of their investments. However, in practice, most people dislike excessive volatility, particularly if their liabilities are uncertain or are short-term.
A suitable strategy is often to switch to less volatile assets as the time at which the investments need to be realised draws near.

Question 22

22. In addition to matching liabilities and allowing for uncertainty, what other investment objective will individuals try to meet?

Answer 22

In addition to the considerations of matching liabilities and allowing for uncertainty, individuals will wish to maximise their expected return.

Question 23

23. Maximising expected return means choosing assets that offer the best returns after allowing for which two factors?

Answer 23

This means selecting assets that are good value after allowing for:
* the expenses of dealing in the asset
* the individual’s tax situation.

Question 24

24. How might an individual’s tax position affect their choice of investments?

Answer 24

Differences in taxation can mean that an investment which is good value to one person can be unsuitable for another. Some investments are particularly efficient for taxpayers. This is usually because the government specifically desires to encourage investment of a particular form. Sometimes investment products are launched that exploit an unintentional tax loophole. These are usually aimed at the wealthy investor and can have a very short lifespan before the loophole is closed.

Question 25

25. Describe the factors that determine the risk appetite of an individual investor.

Answer 25

Individuals may be constrained in their choice of investments by the size of their l iabilities relative to their assets. They will often not be in a position to accept very much risk.
Attitude to risk is partly a personal matter as well as being dependent on an investor’s financial position.

Question 26

26. How can risk be reduced?

Answer 26

Risk can be reduced by diversifying assets both between and within asset classes.

Question 27

27. How will uncertainty influence the individual’s investment decision?

Answer 27

A major constraint is uncertainty. Individuals may lose much of their income for a variety of reasons, such as redundancy or ill health. Similarly unexpected expenditure requirements can easily occur. Therefore it will be desirable to keep some assets in a reasonably liquid form. Insurance can also be used to mitigate the effect of some types of uncertainty.

Question 28

28. Give three practical considerations that don’t affect institutions but might influence an individual’s investment decision.

Answer 28

Individuals usually face practical constraints not suffered by institutions. These can include:
* not enough assets for direct investment in some asset classes
* high relative expenses when investing small amounts
* lack of information and/or expertise.