Institutional Asset Owners and Investment Policies

Question 1

Four types of pension funds

Answer 1

1. National Pension Funds
2. Private Defined Benefit Pension Funds
3. Private Defined Contribution
4. Individually Managed Accounts

Question 2

Four Main decisions to address in the institutional investment process

Answer 2

strategic asset allocation, fund selection, method of diversification, and liquidity management

Question 3

What is Strategic Asset Allocation?

Answer 3

(SAA) creates a portfolio allocation that will provide the asset owner with the optimal balance between risk and return over a long-term investment horizon

Question 4

Why are long-term returns from alternative asset classes hard to estimate?

Answer 4

Some asset classes are new, Alpha decay, Innovative new solutions come up

Question 5

an objective

Answer 5

objective is a preference that distinguishes an optimal solution from a suboptimal solution

Question 6

Types of constraints

Answer 6

Internal (imposed by the asset owner) and external (not under direct control of asset owner)

Question 7

Types of internal/external constraints

Answer 7

Internal
1. Liquidity
2. Time Horizon
3. Sector & Country limits
External
1. Tax status
2. Regulations

Question 8

Investment policy statement (IPS)

Answer 8

a document that describes the primary goals for an investment program and lays out a framework to achieve those goals

Question 9

Six benefits to a good IPS

Answer 9

1. Articulates the investors long-term investment objectives and outlines policies to help meet those objectives.
2. Provides guidance around risk tolerance and investment beliefs of the investor and governing bodies.
3. Monitors the investment program and measures outcomes against objectives.
4. Helps new staff, board, and investment/finance committee members get up to speed on investments.
5. Allows the investor to maintain focus on important strategic issues and take a holistic view.
6. Serves as a roadmap for the fiduciaries and provides guidance throughout all phases of the market cycle.

Question 10

What does the first part of an IPS contain

Answer 10

Description of asset owner, scope of the IPS, fiduciary standards, purpose of IPS

Question 11

5 Most common decision-making parties included in an IPS

Answer 11

Board, IC, Internal staff, Investment adviser(s), Trustees/Custodians

Question 12

IC Responsibilities

Answer 12

• Periodically review IPS / recommend changes
• Periodically review and evaluate investment results
• Selecting/Monitoring investment managers
• Selecting/Monitoring custodians and other SPs

Question 13

Common investment objective of endowments

Answer 13

a return target X% above inflation, specifically connected to long-term spending needs.

Question 14

Common investment objective of pension funds

Answer 14

a return target X% above the liability discount rate

Question 15

Topics for additional consideration in IPS (4 examples)

Answer 15

1. Responsible Investing
2. Proxy Voting
3. Brokerage and other investment related expenses
4. Liquidity policy

Question 16

How are foundations different from endowments? (4 differences)

Answer 16

1. Grant-making institutions
2. Finite lives
3. Subject to minimum spending rates
4. Less likely to be funded from ongoing donations

Question 17

Operating foundations

Answer 17

Income generated by an endowment is used to fund the operations of the charitable organization (most similar to endowment)

Question 18

Change in endowment or foundation value

Answer 18

Income from gifts - Spending + Net investment Returns

Question 19

Foundation spending requirement

Answer 19

minimum 5% per year on operating expenses and charitably activities

Question 20

Six attributes of the endowment model

Answer 20

1. Aggressive asset allocation
2. Effective investment manager research
3. First-mover advantage
4. Access to network of talented alumni
5. Acceptance of liquidity risk
6. Sophisticated investment staff and board oversight

Question 21

Return Attribution

Answer 21

Contributions from SAA + Security Selection + Market Timing or Asset Allocation

Question 22

liquidity-driven investing

Answer 22

an investment approach emphasizing the role of the liquidity of investments and the time horizon of the investor in the asset allocation decisions

Question 23

Three approaches to managing the assets of a DB plan

Answer 23

1. Asset-focused risk mgt. (riskiness measured in assets only)
2. Asset-Liability Risk mgt. (minimize surplus risk)
3. Integrated Asset-Liability Risk mgt. (funding status is considered)

Question 24

Four Factors Driving the Impact of Liabilities on a Plan’s Risk

Answer 24

1. Change in interest rates (most important)
2. Inflation
3. Retirement Cycle
4. Mortality Rate

Question 25

accumulated benefit obligation (ABO)

Answer 25

PV benefits currently accumulated by workers and retirees. (small for young firms; easy to calculate)

Question 26

surplus risk

Answer 26

the volatility and tracking error of value of assets vs liabilities (PBO)

Question 27

Liability-driven investing (LDI)

Answer 27

Minimize surplus risk by building a portfolio with assets that have a high correlation with the change in plans liabilities

Question 28

Financial phases relative to retirement

Answer 28

accumulation phase and decumulation phase

Question 29

3 Risks to retirees

Answer 29

1. Longevity risk 2. Market risk 3. Inflation risk

Question 30

Reserve account of a Central Bank

Answer 30

consists of central bank's holdings of foreign currency

Question 31

Balance of payments formula

Answer 31

Reserve account = Current Account + Capital Account

Question 32

Current account deficit

Answer 32

Deficit: imports > exports

Question 33

Capital Account Surplus

Answer 33

Imported Capital > Exported Capital

Question 34

Gwartney et al. (2003) explains that currencies are likely to appreciate when (5 criteria):

Answer 34

1. Lower inflation rate 2. Higher real interest rate 3. Policies that attract capital 4. Slower income growth 5. Competitive advantage in export-oriented industry

Question 35

Four types of Sovereign Wealth Funds

Answer 35

1. Stabilization Fund (Countercyclical) 2. Savings Fund (Intergenerational Equity) 3. Reserve Funds (Pension or Investment) 4. Development Funds (Socio-economic objectives)

Question 36

Four common motivations for a SWF

Answer 36

1. Protect Nation's economy 2. Counter unwanted liquidity 3. Grow level of savings for future generations 4. Invest money in infra (move away from commodities)

Question 37

Asset allocations per type of SWF

Answer 37

Stabilization -> Mostly fixed income Savings/Reserve -> Highly diversified Reserve -> Mostly equities

Question 38

Two types of sterilization

Answer 38

1. intervene in fx markets to prevent fx appreciation | 2. invest in dollar or euro denominated securities outside home country

Question 39

Reserve adequacy

Answer 39

estimated size for stabilization fund before investing in risky assets

Question 40

Linaburg-Maduell Transparency Index (4 principles)

Answer 40

1. Fund Manages own website 2. Fund identifies external managers, if applicable 3. Fund provides clear strategies & objectives 4. Fund provides up-to-date annual statements

Question 41

Santiago principles (4 points)

Answer 41

1. Clear investment policy 2. Diligence, prudence, and skill in investment practices 3. Only focus on maximization of risk adjusted returns 4. Not seeking advances of privileged information

Question 42

Four macroeconomic variables that define each asset class

Answer 42

Asset Class Return = Real Return + Inflation + Growth + Risk Premium

Question 43

3 ways a family office can increase tax efficiency with hedge funds

Answer 43

1. Focus on investments with a long term horizon (> 1y) 2. Invest in HF managers that trade more 1256 securities. 3. Select tax-efficient managers