Chapter 15: Choosing an appropriate investment strategy

Question 1

What criteria should the investment objectives of an institutional investor satisfy?

Answer 1

1. Clearly states
2. Quantified where possible
3. Objectives should be framed in such a way as to encompass the permitted degree of risk as well as the required total return and cashflow timing.

Question 2

Give examples of possible investment objectives for an institutional investor

Answer 2

• To meet the liabilities as they fall due
• Control the incidence of future obligations on a third party
• To provide sufficient funds to be able to demonstrate ability to meet the liabilities as they fall due (can be on statutory or realistic basis).
• To demonstrate that there are sufficient funds to meet the liabilities if discontinuance where to occur.

Question 3

Discuss how risk can be defined

Answer 3

1. It can be used to describe the probability of an investment failing completely
2. To signify the expected variability of the return from an investment (The variance or std of returns over a single time period)
3. The probability of complete ruin
4. The most practical definition of risk is the probability of failing to achieve the investor’s objective

Question 4

List the factors that the risk appetite of an institutional investor depends on

Answer 4

• The nature of the institution
• The constraints of its governing body and documentation
• Legal or statutory controls

Question 5

List the 15 factors that influence an institutional investor’s investment strategy

Answer 5

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

Question 6

What are the main aspects of liabilities to be considered when creating an investment strategy?

Answer 6

• Nature
• Term
• Certainty
• Currency

Institutions need to be aware of the long-term 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 liability outgo also needs to be considered.
Institutions with uncertain liabilities will need to have higher liquidity buffers.

Question 7

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

Answer 7

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 8

Why will the investor want to maximize returns subject to constraints?

Answer 8

• To attract new business
• Maximise shareholders’ returns
• Minimise the cost of providing for the liabilities

Question 9

What are the main factors an individual should consider before investing?

Answer 9

• Their assets and liabilities and matching cashflows
• Risks arising, in particular the variability of market values
• Returns from different asset classes
• Constraints, both investment and practical constraints.

Question 10

List the features of an individual investors’ liabilities

Answer 10

• Nature
• Term
• Currency
• Level of uncertainty of the liabilities

Question 11

Outline the characteristics of the liabilities of an individual

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

Outline the characteristics of the assets of an individual

Answer 12

1. Consists of current wealth and future income
2. Occupational income: a real asset
3. Pensioners income: may be fixed in nature
4. Uncertainty in relation to receipt of income

Question 13

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

Answer 13

Liquid assets or consider using insurance.

Question 14

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

Answer 14

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 15

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

Answer 15

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 16

How can retired individuals generate sufficient income to live on from the assets that they own?

Answer 16

1. Annuities
2. High income yielding assets
3. Periodic redemption of assets
4. Periodic sale of low income yielding assets