Chapter 15: Choosing an appropriate investment strategy Flashcards
What are the institutional investment objectives?
Institutional investment objectives
- Investment objectives should be clearly stated and quantified – to be able to objectively monitor its success or otherwise in meeting its objectives
- Often necessary and appropriate to invest in risky assets – objectives must be framed to include the permitted degree of risk and required total return and cashflow timing
- Objectives can be:
Meet the liabilities as they fall due
Proving that will be able to do so on ongoing basis
Proving that it could do so on discontinuance basis
Control the incidence of future obligations on a third party (e.g. employer’s contribution rate to pension scheme)
- Concept of meeting liabilities is more complex if they continue to grow/accrue
- Meeting liabilities as they fall due and proving that there are sufficient resources to do so are separate objectives – but both must be met for a continuing entity
- May also be need to demonstrate that there are sufficient assets available should provision of future benefits be discontinued
What are the two interpretations of risk for institutional investors?
Risk for institutional investors
- Risk can be used to describe the probability of an investment failing completely OR to signify the expected variability of the return from an investment
- Two possible interpretations of risk are thus:
Probability of default
Variance or std of returns over a single time period
- From a business point of view, neither definition is entirely satisfactory:
Probability of complete ruin from well-diversifies portfolio is small
Short-term variability in the market value of portfolio is of little relevance to many institutions, where value of liabilities changes with value of assets
Risk as variability of return
- When defining investment risk, we must consider:
The time period being considered
Whether returns are measured in real or nominal terms
The currency in which returns are measured
Risk as probability of failure to achieve investment objective
- Difficult to say asset is risky unless we know the specific objectives of the investor
- Asset that is risky to one may be risk-free for another – depends on how well asset helps investor to meet its objectives
- For investors with explicit liabilities this reflects how well asset matches liabilities
- Perfect match means no risk
- Greater the mismatch the greater the risk
- But investors are subject to many different risks – for many the risk of underperforming compared with competitors is one of the most pressing day-to-day risk
- This is called relative performance risk
- Consequences of underperformance for investment and unit trusts:
Aim, normally, is to provide highest possible return to investors within constraints set by stated
Performance comparisons usually straightforward given that objectives of competitors will be very similar
What will the risk appetite of an institution depend on and who decides on the level of risk that is acceptable?
Risk appetite
- Risk appetite of an institution will depend on:
Nature of institution
Constraints of its governing body and documentation
Legal or statutory controls
- Ultimate decision on how much risk is acceptable will depend on risk appetite of key stakeholders, e.g. for employer-sponsored defined benefit scheme:
Trustees may wish to take less investment risk so to ensure member’s benefits can be paid
Sponsor may wish to take more investment risk as higher investment returns may reduce required contributions
- Additional legal and statutory constraints likely to increase aversion of the institution to risk
What are the main factors influencing an institution’s investment strategy?
Factors influencing an institution’s investment strategy
The main factors
- Nature of existing liabilities – fixed in monetary terms, real or varying in some way
- Currency of existing liabilities
- Term of existing liabilities
- Level of uncertainty of existing liabilities – amount and timing
- Tax and expenses – tax treatment of different investments and tax position of investor need to be considered
- Statutory, legal or voluntary restrictions on how the fund may invest
- Size of the assets – in relation to the liabilities and in absolute terms
- Expected long-term return from various asset classes
- Accounting rules
- Statutory valuation and solvency requirements
- Future accrual of liabilities
- Existing asset portfolio
- Strategy followed by other funds
- Institution’s risk appetite
- Institution’s objectives
- Need for diversification
What are the main factors influencing an institution’s investment strategy? - Liabilities
Liabilities
- Main factor influencing the long-term investment strategy of institutional investor
- Aspects considered nature, term, certainty and currency of liabilities
- Institutions need to be aware of long-term investment strategy which will most closely match their liabilities by nature, currency and term.
- If they do not or cannot adopt such strategy other strategies should be evaluated against this benchmark
Uncertainty
- Uncertainty of liability outgo, both in timing and amount, need to be considered
- Institutions with uncertain liabilities will need higher liquidity buffers
- E.g. general insurance company, where both timing and amounts of claims may be unpredictable, must hold sufficient level of liquid assets
- Complications for some investors when try define their liabilities
- They may have two different sets of liabilities to match:
Liabilities that they need to meet on ongoing basis
Statutory basis for proving solvency
- Likely that assets which best match ongoing liabilities may not be best match for liabilities under statutory valuation
Term
- Investors who have low present cashflows requirement may prefer low income yielding investments to avoid expenses and uncertainty of reinvesting income
- Those who need current income may prefer high income yielding investments to avoid expenses and uncertainty or realising assets
Currency
- Any investor may decide to mismatch liabilities by currency
- For investor wanting to maximise returns in domestic currency necessary to allow for expected changes in currencies over period of investment
- Exposed to risk that return on asset may not be as expected and exchange rate may be worse than expected leading to further losses
- If exchange rate performs better than expected investor would make gains from overseas investment
- Needs to ensure that potential gains are sufficient given additional risks
What are the main factors influencing an institution’s investment strategy? - Return
Return
- In some circumstances the liabilities are not absolutely critical and maximising returns may be more important, e.g.:
Liabilities under money-purchase pension plan (whatever value of fund turns out to be)
Liabilities under unit-linked savings contract (unit fund value)
Future bonuses under with-profit insurance contract
- In above cases, value of liabilities is implied by that of the assets – there is not matching problem and provider arguably free to maximise returns
- But liabilities are still a factor e.g.:
Responsibility to achieve reasonable real return for beneficiaries of money-purchase pension scheme
To meet expectations of with-profit or unit-linked policyholders
What are the main factors influencing an institution’s investment strategy? - Constraint on investment strategy
Constraints on investment strategy
- Institutions may need strategy that will continues to satisfy requirement of regulators
- Investment fund should act in accordance with expectations of its investors, which are influenced by:
Any explicitly stated objectives
Marketing literature
Past investment policy of fund
What are the main factors influencing an institution’s investment strategy? - Size of the assets both in absolute terms and relative to the liabilities
Size of the assets – absolute
- Small fund may be unable to invest in some of available assets – unable to achieve appropriate level of diversification
Size of the assets – relative to the liabilities
- Having assets in excess of liabilities most important reason why investment manager may have freedom to mismatch
- Bigger the free assets the more scope investment manager has for mismatching because bigger cushion with which to absorb any mismatching losses
What are the main factors influencing an institution’s investment strategy? - Tax
Tax
- Investors’ preferences from income or capital growth from investments are governed by two factors:
Tax
Cashflow requirements
- Prefer to receive as much of its total return as possible in lower-taxed form -if institution subject to different taxation bases on income and capital gains
- Market price of low-income securities pushed up if many investors have preference for capital gains
- Thus, need to consider relative preferences of different investors
What are the main factors influencing an institution’s investment strategy? - Diversification
Diversification for institutions
- Assets are diversified if low level of correlation between returns from assets
- Portfolios that are highly correlated are more volatile and more specific risk
- No extra return is available for specific risk as it can be diversified away – according to CAPM
- So important that portfolio should be diversified both within each asset category and different individual company shares
- When selecting individual investments, the NB factor for institution is affect that investment will have on performance of total portfolio
- So after-tax expected return and variability of the return are NB
- But so is the covariance of that return with the rest of the portfolio
- Investment that have low covariance with rest of portfolio represent diversification and will reduce overall risk
What is the main aim of an institution’s investment strategy?
- An institutional investor will seek to maximise investment return
- May be for competitive reason, in order to continue to:
Attract new business
Maximise shareholders’ returns
Minimise cost of providing for liabilities
What are the main factors influencing an individual’s investment strategy?
Factors influencing an individual’s investment strategy
- Main factors considered by individual do not differ greatly from those considered by an institution
- Balance between factors and details do differ
- Main factors that individual should considered before investing are:
Assets and liabilities and matching cashflows
Risks arising – particularly the variability of market values
Returns from different asset classes
Constraints – both investment and practical
What are the main factors influencing an individual’s investment strategy? - Assets and Liabilities
Assets
- Individual’s assets consist on current wealth and future income
- Employment – main component of income
- Other sources: inheritance, maintenance payments and social security
- Nature of income (fixed, real, or varying in some other way) should be considered
Liabilities
- Consist of future spending – including any debt repayments
- Both term and nature and expected level of future spending will need to be considered
- Many people’s expenditure will tend to follow current income level closely
- Likely pattern of future expenditure may form important part of financial planning
- Sophistication of planning process used by individuals will vary greatly
- Most will take account of pattern of their expected future income and major likely expenditure in making their plans
What are the main factors influencing an individual’s investment strategy? - Matching Cashflows
Matching cashflows
- Many individual investors (retired) rely on income from their retirement savings and other investments for basic lifestyle needs
- Thus, necessary to find strategy which will provide high enough current income while allowing for sufficient growth of capital and income to maintain level of income in real terms
- NB that purchasing power of income is maintained throughout retirement and not depleted by inflation
- Strategy should ensure that income is received for duration of life of retiree and dependants
- Strategy thus needs to balance need for providing high enough level of real income against ensuring that retiree does not outlive assets
- In SA when individual retires, they can take up to 1/3 of their fund balance in cash and remaining balance must by law be used to secure income
- So, retirees from defined contribution funds have choice of using retirement fund to purchase guaranteed annuity from life insurance company OR
- Living annuity from approved income provider
- Guaranteed annuity is paid for life of annuitant and, usually, the spouse or dependants – meets need for income payable for their remaining lifetime
- Costs can be quite high which may result in lower level initial income than require by retiree
- Important for annuity to provide for annual increases in order to keep up with inflation during retirement
- Cost of guaranteed annuity has led many retirees to choose living annuity instead
- With a living annuity retiree can select their level of income each year to be high enough to meet needs
- Income is drawn down from their fund balance
- Risk that fund balance is depleted too quickly as result of high drawdowns and balance becomes too low to support them during retirement
- Investors investing for long term and who don’t require current income from investments – concerned with reinvestment of income and maturity proceeds and freer to concentrate on maximising total return
What are the main factors influencing an individual’s investment strategy? - Matching Cashflows by nature, term, currency and uncertainty
Nature
- Most individual’s liabilities will be real in nature (increase with inflation) – although relevant index may not be any particular inflation index
- Occupational income = real income stream
- Pensioners = largely fixed income
- Increases in different real liabilities may be subject to different rates of inflation
- Same is true of future income – salaries may increase with wage inflation
- Because liabilities will generally be real, assets for long-term investment should usually be real
- But monetary assets may be chosen for short-term investments, diversification, because individual is risk averse or because appear to be good value
- E.g. cash deposits with bank offer both liquidity and prospects of good returns when short-term interest rates are high
Term
- For many, income with exceed necessary expenditure while in employment but will not following retirement
- So much of investment by individuals should be geared towards providing for period after normal employment
- Despite this, individuals will often tend to have shorter-term outlook
Currency
- Most investors will have liabilities and hence want assets traded in their domestic currency
- Investors can still obtain exposure to other currencies and overseas markets through investment funds and overseas earnings from domestic companies
Uncertainty
- Level of uncertainty regarding future income and expenditure will affect the investment strategy
- High levels of uncertainty will lead to a need for more:
Liquid assets
Insurance
What are the risk of an individual investment strategy?
Risk
- Variability of market values
- Individuals should be more relaxed about volatility of asset values than some of the institutions
- Individuals are not required to prove their solvency
- Random fluctuations ought not trouble those investors saving for the distant future
- Individuals investing for long term may not be concerned about short-term variations in market value of investments
- Most people dislike excessive volatility – particularly if liabilities are uncertain or are short term
- Theoretical argument is that asset volatility should not generally concern individuals – most people have short time horizons so that stability of asset values becomes important
- Suitable strategy is to switch to less volatile assets as time at which investment need to be realised draws near
Diversification
- Risk can be reduced by diversifying assets both between and within asset classes
- CISs are very important ways for personal investors to maintain high levels of diversification
What will need to be considered by individual investors when trying to maximise their expected return?
Returns from assets
- Individuals will wish to maximise their expected return
- This means selecting assets that are good value after allowing for:
The expenses of dealing in the asset
The individual’s tax situation
Taxation
- Taxation is NB factor within investment planning for individual because:
Tax rates may be relatively high for some individuals
Of the varying tax treatment of different investment vehicles available to individuals
- Difference in taxation can mean that investment which is good value to one person is unsuitable for another
- Some investments are efficient for taxpayers – because government specifically desires to encourage investment of particular form
- Sometimes investment products launched that exploit unintentional tax loophole – aimed at wealthier investor and can have very short lifespan before loophole is closed
‘Feel-good’ factors
- The word return could mean more than just income and capital for certain types of investors
- Personal investors more likely to be influenced by rather subjective factors
- E.g. some individuals may derive gratification from owning large houses and fine painting
- In general, tangible assets are more likely to produce feel-good factor than say government bonds
Discuss the main investment constraints for individual investors.
Investment constraints
- Arise due to issues around matching and risk, for example:
1. Excess assets - Individuals may be constrained in choice of investments by the size of liabilities relative to their assets
- Will often not be in a position to accept very much risk
2. Uncertainty of future income and outgo - Major constraint is uncertainty
- Individuals may lose much of income for many reasons, e.g. redundancy and ill health
- Unexpected expenditure requirements can easily occur
- Thus, will be desirable to keep some assets in reasonable liquid form
- Insurance can be used to mitigate effect of some types of uncertainty
- Uncertainty could be one of considerations influencing investment decision of individual investors – can be reduced by insurance
- Insurance can be used to help individuals to:
Follows better investment strategy i.e. higher risk and higher expected return
Have better spending plan i.e. less need to hold back large sums of money to meet contingent liabilities
- Risk appetite
- Personal
- Dependent on investor’s financial position
- This may be partly by function of:
Age – older people more risk averse = less time to make up any loss
Wealth – richer people more aggressive in investment strategy
Dependants – those with dependants = more cautious
- Practical constraints
- Individuals face practical constraint not suffered by institutions
- These include:
Not enough assets for direct investment in some asset classes
High relative expenses when investing small amount
Lack of information and/or expertise
- CISs may help reduce impact of such constraints
