Chapter 15 - Choosing an appropriate investment strategy

Question 1

What are the types of objectives an institutional investor aims to meet

Answer 1

MADAMS T

• MEETING liabilities as they fall due
• ACHIEVING a pre-specified target level of investment return or funding level
• DEMONSTRATE that there are sufficient assets available should the provision of future benefits be discontinued
• Controlling the AMOUNT and timing of benefits
• MATCHING or exceeding competitors – e.g. the median return or funding level
• Satisfying STATUTORY solvency requirements
• TRACKING an index as closely as possible

Question 2

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

Answer 2

CRAFTSPERSON EAT DUO

Currency of the existing liabilities
Risk appetite of institution
size of the Assets in relation to liabilities (absolute / relative)
Future accrual of liabilities
Tax treatment of the assets / investor
Statutory valuation and solvency requirements
existing asset Portfolio
Expenses
expected L/T Return from various asset classes
Statutory/legal / voluntary restrictions on how the fund may invest
Objectives of the institute
Nature of existing liabilities- fixed in monetary, real or varying

ESG considerations
Accounting rules
Term of the existing liabilities

need for Diversification
Uncertainty of existing liabilities - timing and amount
Other funds’ strategies (competition)

Question 3

When would an overseas market be considered ‘cheap’?

Answer 3

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 4

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

Answer 4

ME MANDRILL

• MATCHING the nature, term, currency and uncertainty of the liabilities.
• High relative EXPENSES when investing small amounts
• MAXIMISING expected return on investments, net of expenses and tax
• A need for income to live on vs growth for the future
• NOT enough assets for direct investment in certain asset classes
• DIVERSIFICATION, to reduce specific risk
• RISK aversion and a dislike of volatility
• The INDIVIDUAL’S tax status and the tax treatment of the asset
• LOW free assets, which constrain the ability to mismatch and take risks
• LACK of information/expertise relative to institutional investors.

Question 5

4 Common problems of switching large portfolios

Answer 5

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

Question 6

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

Answer 6

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

Question 7

Main factors an individual should consider before investing

Answer 7

CARR

• CONSTRAINTS, both investment and practical constraints
• their ASSETS and liabilities and matching cashflows
• RISKS arising, in particular, the variability of market values
• RETURNS from different asset classes

Question 8

4 Definitions of Risk

Answer 8

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