CHP 25

Question 1

1. Institutional investment objectives

Answer 1

Investment objectives should be clearly stated and quantified where possible.
Since it is often necessary and appropriate to invest in risky assets, the objectives must be framed in such a way:
• to encompass the allowable degree of risk and
• the required total return and
• cashflow timing

Question 2

investment Objectives can be described in various ways:

Answer 2

• Meet liabilities as they fall due, or
• The objective could be to control the incidence of future obligations on a third party (e.g. employer contribution rate to a pension scheme).
The concept of meeting liabilities becomes more complex if liabilities continue to accrue (e.g. open pension scheme).
For a continuing entity, meeting liabilities as they fall due and proving that there are sufficient resources to do so are separate objectives – both have to be met.
There may be a need to illustrate that there are enough assets available should the provision of future benefits be stopped.

Question 3

Investmetn risk

Answer 3

Risk – mostly used to describe the expected variability of the return from an investment or the probability of default.
From a business perspective, this is not satisfactory as an institutional investor will have a diversified portfolio with risk of default being very small. Also, the short-term variability of returns is of little relevance to most institutions, since it takes no account of changes in liability as the asset portfolio changes.

Question 4

2.2. Risk as a probability of failure to achieve investment objective

Answer 4

The most practical definition of risk is the probability of failing to achieve the investor’s objective.
However, it must be recognized that investors are subject to many different risks. For many, the most important risk is underperformance relative to other institutions (relative performance risk).

Question 5

Risk appetite of an institution will depend on:

Answer 5

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

Question 6

3. Factors influencing investment strategy

Answer 6

The principle aim of an investing institution is to meet liabilities as they fall due, the overriding need is to minimize risk.

Question 7

The main factors that will influence long-term investment strategy are:

Answer 7

1. Nature of existing liabilities – fixed in monetary terms, real or varying in some other way.
2. Currency of existing liabilities
3. Term of existing liabilities
4. Level of uncertainty of existing liabilities – both amount and timing
5. Tax – tax treatment of different investments and tax position of the institution
6. Statutory, legal or voluntary restrictions on how the fund may invest
7. Size of the assets – both in relation to the liabilities and in absolute terms
8. Expected long-term return from various asset classes
9. Statutory valuation and solvency requirements
10. Future accrual of liabilities
11. Existing asset portfolio
12. Strategy followed by other funds
13. Institution’s risk appetite
14. Institution’s objectives
15. Need for diversification.

Question 8

1. Liabilities:

Answer 8

• Nature
• Currency
• Term
• Uncertainty
• Future accrual

Question 9

2. Expected returns:

Answer 9

• Returns from different asset classes

* Allowing for tax

Question 10

3. Benchmarks and restrictions:

Answer 10

• Investment restrictions
• Other similar funds
• Statutory valuation and solvency

Question 11

4. Circumstances of investor:

Answer 11

• Assets vs liabilities (i.e. size factors)
• Existing portfolio
• Risk prepared to take
• Objectives
• The need for diversification

Question 12

Liabilities

Answer 12

Institutions need to be aware of the long-term strategy that will best match their liabilities in nature, currency and term.
Even if they do not or cannot adopt this strategy, other strategies should be evaluated against this benchmark.
Uncertainty in timing and amount of liabilities needs to be considered – hold marketable assets for this.

Question 13

Restrictions and constraints on investment strategy

Answer 13

Institutions may need a strategy that will continue to satisfy the requirements of regulators.

Question 14

Income and capital growth

Answer 14

preferences are governed by tax and cashflow requirements. Investors with low cashflow requirements may prefer low income yielding assets to avoid expense and reinvestment. The converse is also true.

Question 15

Income and volatility

Answer 15

For some institutional investors with a long-term horizon, the fluctuations in asset values are not a concern (especially if the asset is to be held to maturity).
It may however be important to institutions that must demonstrate solvency on a market valuation basis regularly and have a low level of free assets.
Fluctuations in asset values are also disliked by some retail customers of institutions.

Question 16

Subject to the above, the investment institution will seek to maximize returns. This may be:

Answer 16

• For competitive reasons
• To continue to attract new business
• Maximize shareholders’ returns
• Minimize the cost of providing for liabilities.

Question 17

4. Tactical asset allocation

Answer 17

An attempt to maximize return may involve tactical asset allocation, this is a departure from the benchmark position and hence conflicts with minimizing risk. The size of the assets relative to the liabilities will determine the risk for such an action.

Question 18

Factors to be considered before making a tactical asset switch are:

Answer 18

• The expected additional returns relative to the additional risk
• Constraints on the changes that can be made to the portfolio
• Expenses of making the switch
• Problems of switching a large portfolio of assets.

Question 19

5. Selecting individual investments - diversification

Answer 19

The important factor to consider is what the effect of the investment will be on the performance of the total portfolio. Thus the covariance of the return of the asset with the rest of the portfolio (along with after tax expected return and variability).
Low covariance reduces overall risk. For any investment type there are many issues to be considered.