Institutional Asset Owners and Investment Policies Flashcards
Four types of pension funds
- National Pension Funds
- Private Defined Benefit Pension Funds
- Private Defined Contribution
- Individually Managed Accounts
Four Main decisions to address in the institutional investment process
strategic asset allocation, fund selection, method of diversification, and liquidity management
What is Strategic Asset Allocation?
(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
Why are long-term returns from alternative asset classes hard to estimate?
Some asset classes are new, Alpha decay, Innovative new solutions come up
an objective
objective is a preference that distinguishes an optimal solution from a suboptimal solution
Types of constraints
Internal (imposed by the asset owner) and external (not under direct control of asset owner)
Types of internal/external constraints
Internal 1. Liquidity 2. Time Horizon 3. Sector & Country limits External 1. Tax status 2. Regulations
Investment policy statement (IPS)
a document that describes the primary goals for an investment program and lays out a framework to achieve those goals
Six benefits to a good IPS
- Articulates the investors long-term investment objectives and outlines policies to help meet those objectives.
- Provides guidance around risk tolerance and investment beliefs of the investor and governing bodies.
- Monitors the investment program and measures outcomes against objectives.
- Helps new staff, board, and investment/finance committee members get up to speed on investments.
- Allows the investor to maintain focus on important strategic issues and take a holistic view.
- Serves as a roadmap for the fiduciaries and provides guidance throughout all phases of the market cycle.
What does the first part of an IPS contain
Description of asset owner, scope of the IPS, fiduciary standards, purpose of IPS
5 Most common decision-making parties included in an IPS
Board, IC, Internal staff, Investment adviser(s), Trustees/Custodians
IC Responsibilities
- Periodically review IPS / recommend changes
- Periodically review and evaluate investment results
- Selecting/Monitoring investment managers
- Selecting/Monitoring custodians and other SPs
Common investment objective of endowments
a return target X% above inflation, specifically connected to long-term spending needs.
Common investment objective of pension funds
a return target X% above the liability discount rate
Topics for additional consideration in IPS (4 examples)
- Responsible Investing
- Proxy Voting
- Brokerage and other investment related expenses
- Liquidity policy
How are foundations different from endowments? (4 differences)
- Grant-making institutions
- Finite lives
- Subject to minimum spending rates
- Less likely to be funded from ongoing donations
Operating foundations
Income generated by an endowment is used to fund the operations of the charitable organization (most similar to endowment)
Change in endowment or foundation value
Income from gifts - Spending + Net investment Returns
Foundation spending requirement
minimum 5% per year on operating expenses and charitably activities
Six attributes of the endowment model
- Aggressive asset allocation
- Effective investment manager research
- First-mover advantage
- Access to network of talented alumni
- Acceptance of liquidity risk
- Sophisticated investment staff and board oversight
Return Attribution
Contributions from SAA + Security Selection + Market Timing or Asset Allocation
liquidity-driven investing
an investment approach emphasizing the role of the liquidity of investments and the time horizon of the investor in the asset allocation decisions
Three approaches to managing the assets of a DB plan
- Asset-focused risk mgt. (riskiness measured in assets only)
- Asset-Liability Risk mgt. (minimize surplus risk)
- Integrated Asset-Liability Risk mgt. (funding status is considered)
Four Factors Driving the Impact of Liabilities on a Plan’s Risk
- Change in interest rates (most important)
- Inflation
- Retirement Cycle
- Mortality Rate
accumulated benefit obligation (ABO)
PV benefits currently accumulated by workers and retirees. (small for young firms; easy to calculate)
surplus risk
the volatility and tracking error of value of assets vs liabilities (PBO)
Liability-driven investing (LDI)
Minimize surplus risk by building a portfolio with assets that have a high correlation with the change in plans liabilities
Financial phases relative to retirement
accumulation phase and decumulation phase
3 Risks to retirees
- Longevity risk
- Market risk
- Inflation risk
Reserve account of a Central Bank
consists of central bank’s holdings of foreign currency
Balance of payments formula
Reserve account = Current Account + Capital Account
Current account deficit
Deficit: imports > exports
Capital Account Surplus
Imported Capital > Exported Capital
Gwartney et al. (2003) explains that currencies are likely to appreciate when (5 criteria):
- Lower inflation rate
- Higher real interest rate
- Policies that attract capital
- Slower income growth
- Competitive advantage in export-oriented industry
Four types of Sovereign Wealth Funds
- Stabilization Fund (Countercyclical)
- Savings Fund (Intergenerational Equity)
- Reserve Funds (Pension or Investment)
- Development Funds (Socio-economic objectives)
Four common motivations for a SWF
- Protect Nation’s economy
- Counter unwanted liquidity
- Grow level of savings for future generations
- Invest money in infra (move away from commodities)
Asset allocations per type of SWF
Stabilization -> Mostly fixed income
Savings/Reserve -> Highly diversified
Reserve -> Mostly equities
Two types of sterilization
- intervene in fx markets to prevent fx appreciation
2. invest in dollar or euro denominated securities outside home country
Reserve adequacy
estimated size for stabilization fund before investing in risky assets
Linaburg-Maduell Transparency Index (4 principles)
- Fund Manages own website
- Fund identifies external managers, if applicable
- Fund provides clear strategies & objectives
- Fund provides up-to-date annual statements
Santiago principles (4 points)
- Clear investment policy
- Diligence, prudence, and skill in investment practices
- Only focus on maximization of risk adjusted returns
- Not seeking advances of privileged information
Four macroeconomic variables that define each asset class
Asset Class Return = Real Return + Inflation + Growth + Risk Premium
3 ways a family office can increase tax efficiency with hedge funds
- Focus on investments with a long term horizon (> 1y)
- Invest in HF managers that trade more 1256 securities.
- Select tax-efficient managers
