Choosing An Appropriate Investment Strategy

Question 1

Institutional investment objectives

Answer 1

The investment objective should be clearly stated and quantified where possible
It should encompass the permitted degree of risk, required return and cashflow timing

Question 2

Ways risk can be defined

Answer 2

Probability of default

Expected variability of return

Risk if underperforming compared with competitors

Probability of failing to achieve the investor’s objectives (most practical when considering investment strategy)

Question 3

What risk appetite depends on

Answer 3

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

Question 4

Factors influencing an institution’s investment strategy

Answer 4

1. The nature of the existing liabilities - whether they are fixed in monetary terms, real or varying in some other way
2. The currency of the existing liabilities
3. The term of the existing liabilities
4. The level of the uncertainty of the existing liabilities- both in amount and timing
5. Tax and expenses - both the treatment of different investments and tax position of the investor needs to be considered
6. Statutory, legal or voluntary restrictions on how the fund may invest
7. The size of the assets, both in relation to the liabilities and in absolute terms
8. The expected long-term return from various asset classes
9. Accounting rules
10. Statutory valuation and solvency requirements
11. Future accrual of liabilities
12. The existing asset portfolio
13. The strategy followed by other funds
14. The institution’s risk appetite
15. The institution’s objectives
16. The need for diversification
17. Environmental, social and governance (ESG) considerations

Question 5

Factors influencing an individual’s investment strategy

Answer 5

1. The characteristics of their assets and liabilities and matching cashflows
   • usually their liabilities are predominantly real (inflation linked) and domestic, so real, domestic assets are preferable
   •consider when asset proceeds are required, i.e when total expenditure exceeds other income and the extent to which they want their investments to provide income as opposed to capital gain
2. Risk
   • the stability of values should not be a major factor for long-term investment, however the short time horizon of many individuals can make stability of asset values seem important
   • diversification is important
3. Returns from different asset classes -considering:
   • any specific tax advantages
   • ‘feel good’ factors (possibly from owning large houses or fine painting) - these come from tangible assets
   • environmental, social and governance factors
4. Investment constraints - investment is constrained by the level of risk the individual can take on, which may depend on:
   • the level of excess assets of the individual
   • the uncertainty of future income and outgo
   • the risk appetite of the investor
5. Practical considerations, which include:
   • if the level of assets are too low to allow direct investment in some assets
   • the relatively high expenses incurred when investing small amounts
   • a likely lack of investment expertise and information