Chapter 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 return and timing of cashflows

Question 2

What are examples of possible investment objectives for an institutional investor?

Answer 2

1> Meet all liabilities as they fall due

2> Control the incidence of future obligation on a third party

3> Provide sufficient funds to be able to demonstrate ability to meet liabilities as they fall due

4> Demonstrate that there are sufficient funds to meet liabilities if discontinuance were to occur.

Question 3

For an institutional investor how might risk be defined?

Answer 3

1> Standard deviation or volatility of return from an investment

2>Probability of ruin

3> Probability of failing to achieve the investors objectives=> underperforming vs Competitors

Question 4

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

Answer 4

1> Nature of the institution=> pension, bank, insurer

2> Constraints of its governing body and documentation

3> Legal or statutory controls

Question 5

What factors influence the long-term investment strategy of an institutional investor?
SOUNDER TRACTORS

Answer 5

1> Size of the assets(absolute/relative)
2> Objectives
3> Uncertainty of the liabilities
4> Nature of the liabilities
5> Diversification
6> Existing asset portfolio
7> Return (expected long term)

8> Tax treatment of the assets/ investor
9> Restrictions- statutory/legal/voluntary
10> Accrual of liabilities in the future
11> Currency of the existing liabilities
12> Term of existing liabilities
13> Other fund’s strategies=> competition
14> Risk appetite
15> Solvency requirements and accounting requirements

Question 6

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

Answer 6

1> An institutional investor may prefer high-income yielding investments if the investor:
i. Currently has high cash outflow requirements and wants to avoid the expense and uncertainty of realising assets
ii. Is not concerned about reinvestment risk
iii. Pays a higher tax on capital gains than on income

Question 7

When would an overseas market be considered cheap?

Answer 7

1> E[RLocal]+ E [depreciation of home currency]> E[RHome]

2> 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 8

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

Answer 8

1> The expected return net of taxes and expenses

2> The volatility of returns

3> Whether the asset selected has a low covariance with the other assets in the portfolio=> diversification=> reduced specific risk

Question 9

Why will an institutional investor seek to maximise the investment return?

Answer 9

1> Competitive reasons=> continue to attract new business

2> Maximise shareholders’ returns

3> Minimise the cost of providing for the liabilities

Question 10

10) What are 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 standard price inflation index

3> Mainly denominated in the domestic currency

4> Both short term and long-term liabilities

5> Some uncertainties in the amount and or timing

Question 11

What are the characteristics of the assets of an individual?

Answer 11

1> Consist of current wealth and future income

2> Occupational income=> a real asset

3> Pension income=> may be fixed in nature

4> Uncertainty in relation to receipt of income=> redundancy or ill health

Question 12

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

Answer 12

1> Liquid assets
2> Insurance

Question 13

What factors will affect the long-term investment strategy of an individual?

Answer 13

1> Matching the characteristics of liabilities

2> Need for income to live vs saving for the future

3> Risk aversion and dislike of volatility

4> Diversification to reduce specific risk

5> Maximising investment return net of taxes and expenses

6> Individuals tax status and the tax treatment of assets

7> Low free assets, which constrains the ability to mismatch and take risk

8> Not enough assets for direct investments in certain asset classes

9> High relative expenses when investing small amounts

10> Lack of information/expertise relative to institutional investors

Question 14

What three factors does a retired individual need 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

15) How can retired individuals generate sufficient income from the assets 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 value of an individual’s assets just prior to retirement be avoided?

Answer 16

1> Suitable strategy=> switch to a less volatile strategy

2> Lifestyling