Chapter 25: Investment Strategy - Institutions Flashcards

1
Q

How should an institutions investment objective be framed?

A

In terms of:

  • required return
  • allowable level of risk
  • timing of the cashflows
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2
Q

Examples of objectives of a pensions scheme

A
  • to meet liabilities as they fall due
  • to control the sponsor’s future contribution rate
  • to have sufficient assets to meet liabilities on an ongoing basis
  • to have sufficient assets to meet liabilities if the scheme discontinues
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3
Q

Examples of what the word “risk” might mean

A
  • standard deviation of investment returns
  • probability of complete ruin
  • probability of failing to meet the investor’s objective
  • risk of underperforming competitors.
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4
Q

Institutional risk appetite depends on (4)

A
  • nature of the institution
  • constraints of its governing body
  • documentation
  • legal or statutory controls
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5
Q

15 Main factors that will influence a long-term investment strategy

A
  • nature
  • term
  • currency
  • uncertainty
    of existing liabilities
  • future accrual of liabilities
  • expected long-term return of various asset classes
  • tax treatment of different assets and of the investor
  • statutory, legal or voluntary restrictions on the investor
  • valuation and solvency requirements
  • the size of the assets in absolute terms and relative to the liabilities
  • the existing portfolio
  • strategy followed by peers
  • risk appetite of the institution
  • institution’s objectives
  • the need for diversification
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6
Q

Why might some investors prefer a low income-yielding assets to high income-yielding assets?

A

There is less income to have to worry about reinvesting (which reduces dealing costs)

Some investors may have little short-term outgo to meet.

Low income-yielding assets may appeal to institutions that pay a high level of income tax relative to capital gains tax.

Low income-yielding assets tend to be more volatile than high income-yielding assets since they have a longer discounted-mean term.
This may appeal to:
- longer-term investors,
- risk seekers,
- investors with significant free assets,
- investors who don’t need to worry about demonstrating solvency on a market value basis.

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7
Q

What should you take into account when selecting individual investments in relation to the existing portfolio.

A

the covariance of the return with the assets in the existing portfolio, and hence the level of diversification and specific risk in the portfolio.

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8
Q

What is meant by a tactical asset allocation?

A

a short-term deviation from the long-term strategy in an attempt to maximise returns.

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9
Q

Factors to consider when making a tactical asset allocation

A
  • extra dealing expenses
  • risk of shifting asset prices by switching a large amount of assets
  • constraints of changes that can be made to the portfolio
  • whether the extra expected return outweighs the additional risk
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10
Q

What are the 2 principles of investment?

A

Liabilities and Assets

Liabilities - Select investments appropriate to the liabilities nature, term and currency and the risk appetite of the provider

Assets - Subject to the liabilities part, maximise overall return on assets (income and capital growth)

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11
Q

8 limitations of investments caused by Regulation

A

Currency to match A and L
Amounts of specifics asset used for solvency demonstrations
Mismatch reserve needed
Proportions of particular assets needed e.g. gilts

Custodianship of assets
Type of asset

Mismatching limit to the extent of it
Exposure to counterparty limits

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12
Q

What is mismatching?

A

Holding assets that don’t match the nature of liabilities

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13
Q

Factors effecting investment strategy?

A

SOUNDER TRACTORS

Size of assets (absolute and relative)
Objectives
Uncertainty to liabilities
Nature of liabilities
Diversification
Existing portfolio
Return (expected long-term)
Tax treatment of assets/investor
Restrictions (legal, stat, voluntary)
Accrual of liabilities
Currency of existing liabilities
Term of existing liabilities
Other funds' strategies (competitors)
Risk appetite
Solvency requirements
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14
Q

How can you split the investment strategy factors?

A

Assets/liabilities/regulation/company

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15
Q

What liability factors effect investment strategy

A
Fixed/variable (nature)
real/not real
currency
term
uncertainty in amount
uncertainty in term
future accrual
size vs assets
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16
Q

What regulatory things effect investment strategy

A

Tax of investments and company
valuation requirements
solvency requirements
restrictions (legal/stat/voluntary) on how fund invests

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17
Q

What assets factors effect investment strategy?

A

Size of assets, absolute and relation to liabilities
Expected long term return
existing portfolio
diversification?

18
Q

What company factors/ideas effect inv strategy

A

Strategy followed by other funds
risk appetite
objectives

19
Q

What 2 particular things should you look at in matching guaranteed liabilities?

A

Term and probability of payments

20
Q

How to invest if inflation linked guarantees?

A

Index linked securities

match expected term of liability outgo

21
Q

How to invest if discretionary benefits?

A

Asset to provide highest expected return subject to policyholder reasonable expectations

22
Q

How to invest if investment-linked guaranteed liabilities

A

Invest in assets relevant to the specific formula guarantees are based on
might use collective investment scheme on FTSE or derivatives

23
Q

How do you hedge guaranteed liabilities

A

Immunisation

24
Q

If you have a large surplus and guaranteed monetary benefits, how/why do you invest it?

A

Use as solvency cushion
mismatch policy
mismatching reserve
finance capital growth and other projects

25
Q

If you have large free surplus and investment-linked liabilities, how do you invest?

A

can’t mismatch due to all risk being then on the policyholder and all profits to you

26
Q

If you have a large surplus and discretionary benefits, how do you invest it?

A

mismatching
buffer against insolvency
limited matching to keep defined benefit level
as long as you take into account p/h reasonable expectations in terms of amount received and level, then do what you want, if in regulations

27
Q

What types of benefit payments are there?

A

Guaranteed in money terms
Guaranteed to an index of prices/earnings or similar
Investment-linked
Discretionary

28
Q

What’s the net liability outgo formula?

A

benefit payments+expense outgo (linked to index) - premium/contribution income (fixed or linked)

29
Q

What things do individuals suffer from that companies don’t when investing?

A

Size of expenses relative to investment
lack of info/expertise
not enough assets for direct investment to some classes

30
Q

Describe active management

A

Restrictions on investments decrease
Judgement used for future long/short term performance on individual investments
Returns should be greater
Costs of extra transactions offset the greater returns
Judgments can be incorrect

31
Q

Describe passive management

A

Bench marked, so hold assets to reflect it
Restricted freedom
Tracking errors possible
Bad performance of index possible

32
Q

What are the 2 types of tracking error measurement?

A

Prospective (forward looking) and Retrospective (backward looking)

33
Q

Explain retrospective tracking error

A

Annualised SD of difference between portfolio and benchmark RETURN

34
Q

Explain prospective tracking error measurement

A

Estimate annualised SD of portfolio return relative to benchmark
Assume current structure of portfolio unaltered
Use quantitative modelling
Volatility assumptions
Correlation assumptions for stocks/markets

35
Q

What are the 3 components of market risk?

A

Strategic, active, structural

36
Q

Explain strategic risk in 2 points

A

Risk of poor performance of strategic benchmark relative to liabilities
Strategic benchmark is closes portfolio to match liabilities

37
Q

Explain active risk in 2 points

A

Risk of poor performance of active fun relative to portfolio benchmark
Measure by tracking error

38
Q

Explain structural risk in 2 points

A

Aggregate of the portfolio benchmarks doesn’t match total fund benchmark
Usually in very small schemes or peer group benchmarking, else small

39
Q

Explain what risk budgeting is?

A

Establish how much risk should be taken
Maximize return by allocating it efficiently
Overall risk allocated between strategic and active risk
Lower risk through diversification and increased expected return are possible because the manager is free to look at this

40
Q

List 6 types of liability hedging

A

Mean-variance optimisation without reference to liabilities
A/L modelling
Currency hedging
Shadow strategy of other institutional investors

A..
Immunisation
Market cap asset allocation

41
Q

What types of problems can liability hedging have (include immunisation)

A

High price of assets to match liabilities
Uncertainty of liability outgo
Length and size of assets may not be possible
ZCB’s risk free are needed for perfect match

Monetary liabilities sorted in immunisation not real
Mismatching profits not possible if immunised
Changes that are large in interest rates are not covered in immunisation
Yield curve not flat in reality for immunisation