Institutional investor Portfolio Management Flashcards
common charactiertics
- scale: asset size AUM
- LT investment horizon
- regulatory framework
- Governance framework
- principle-agent issue
IPS include:
- return: specific, clearly defined, actuarially based, total return focus
- risk:
more objective using established risk measures and formal governance structures to control risk;
greater asset base may allow greater risk to be undertaken - constraint
- liquidity
specific liability steam that is formally managed
plan sponsor is source of regular and extraordinary funding - time horizon:
perpetual/very long
assuming enrollment to new participants remains open - tax
tax-exempt - legal/regulatory
highly regulated by ERISA at the federal level
Norway’s sovereign wealth fund
- passively agreed allocation to public equity & bonds (with traditional 60/40% base allocation )
- little or no exposure to alternative asset
- tight tracking error limits
adv:
low cost and fees
easy for board to comprehend
disadvantage:
no opportunity for outperformance of markets
Yale University endowment
external managed asset
- high allocation to alternatives
- significant active management
- externally managed assets
adv: potential for outperformance of market
disadvantage:
- difficult for small institutions without expertise in alternatives
- may also be difficult for large managers due to capacity issue of external mangers
- high fees/ costs
Canada Pension Fund
internal managed asset
- high allocation to alternative
- significant active management
- internally managed assets
- use a reference portfolio of passive public assets as benchmark that can be easily understand
adv:
- potential for outperformance of market and development of internal capacities
disadvantage:
- potentially expensive and difficult to manage
LDI liability driven
AA:
focus is on maximizing expected surplus
(A-L) return and managing surplus volatility
adv:
explicitly recognizes liabilities as part of inv. process
disadvantage:
certain risk of liability (longevity) are difficult to hedge
DB face mortality/longevity risk
- risk of general increase in life expectancy faced by sponsor
inv. objective:
achieve a target return over a specified LT horizon which assuming a level of risk that is consistent with meeting its contractual liabilities
2rd objective:
minimize PV of cash contributions, the sponsor will be required to provide
DC face longevity risk by employee
- older participant will have shorter investment horizon
- life-cycle option
participant-switching option ( move to more conservative AA as aging)
participant/ cohort option (pooling participant with other investment)
objective:
primary: prudently grow assets to meet spending needs in retirement
2rd: to outperform the passive asset class returns of the default option’s strategic asset allocation
Funded ratio =
fv of pa/ pv of pbo
factor increase liability
- service/tenure
- salary
- longevity
- additional/ matching contribution
factor decrease liability
- increase in discount rate
- return expectation
factor increase risk tolerance
- increase in investment horizon
- plan close to new participants
- fund status surplus
- low debt ratio
- high profitability
- large size of plan
- young workforce
- low correlation with operation result
risk exposure of Pension plan
the lower correlation of sponsor operating results and the returns of pension assets, the greater the risk tolerance of plan
the low correlation implies that in times of plan underperformance, the sponsor is likely to be more profitable and able to increase plan contributions
provision for early retirement
imply a low risk tolerance as the shorter investment horizon means the plan has less time to recover from short-term losses
liquidity need higher when
- the proportion of retired lives in the plan is higher
- the workforce of the employer is older since the time to pay benefits will be shorter
- plan has higher fund status, since this will likely lead to lower sponsor contributions and more benefits part will need to be met from existing plan asset
- the plan participants have the ability to switch or withdraw from the plan, an event that usually triggers payment to participants
external constraints
DB:
regulatory by countries
tax
accounting rule
education for DC plan participants
DC plan are tax deferred
Sovereign wealth funds
main features/mission:
- ## budget stabilization funds
- ## development funds
- saving’s fund
- reserve funds
designed to earn returns on excess return on fx holding by central banks
aim to reduce negative cost of carry through boosting returns or reserves
- pension reserve funds
used to save and invest to meet future pension and liability of government
- budget stabilization funds
FI & CASH
- uncertain liabilities linked to commodity price/ cyclical industries
- short term investment horizon because budget support required on a ST basis
liquidity:
must maintain the highest liquidity level and invest in asset with low risk of significant loss in the short term
inv. objective:
- capital presentation
- aim to earn return above inflation with a low prob of losses
- should avoid assets correlated with the source of gov’t revenues
- development funds
infrastructure project driven by social economic mission
- nature of liabilities linked to socioeconomic investment made by the fund
-some LT horizons infrustrucue
some medium term horizon
liquidity:
liabilities are not clearly defined, low liquidity
inv. objective:
- support a nation’s economic development and increase long-run economic growth
- implicit objective is to earn a real rate of return greater than real domestic GDp growth or productivity growth
- Saving’s fund
equity & alternative PE & real assets
liabilities are linked to future generation , therefore LT
lowest liquidity
inv. objective:
- maintain purchasing power of asset, overtime while making ongoing speeding on gov’t budgeting needs
- reserve funds
similar to saving’s fund but lower allocation to alternatives
- investment horizon are very long
typically no near term liabilties
liquidity:
lower than stabilized fund
but higher than saving funds
inv. objective:
earn a return in excess of yield the gov’t central bank pays on bonds
- pension reserve funds
high equity and alternative due to LT and low liquidity needs
- liabilities are linked to future pension pmt
long term - fund may have an accumulation stage in which contributions are made and a decunulation phrase where benefits are drawn, time horizon will depend on when these stage occur
liquidity:
vary, being lower during the accumulation stage and higher during the decumulation stage
inv. objective:
earn returns to meet future unfunded pension and social pmt provided by the gov’t
University endowments
high risk tolerance from donation and gifts
and low spending rate
primary to reserve the purchasing power of the assets in perpetuity while achieving returns adequate to maintain the level of speeding
second: to outperform a passive BM or a peer group of similar endowment
> 50 % in alternatives
main feature/mission:
set up by gift/ donation while are invested to earn return that provide ongoing support to the university’s operating budget
- has a perpetual investment horizon
spending t+1 = W (spending t * (1+inflation)
+(1-w) * (spending rate * avg AUM)
2 different types of spending policies result from different value of Weight:
- constant growth rule w=1
the endowment provides a fixed (real) annual payment to the university once adjusted for inflation by the higher education price index (HEPI)
Spending rule has caps and floors represent max and min % value of AUM.
- market value rule (w=0)
annual payments are a respecified % (spending rate b/w 4-6%) of the 3-5 year moving average of asset value.
payment are pro cyclical in that speeding will fluctuate in the moving average of asset values - hybrid rule (0
Private foundation
inv. objective:
primary: generate a real return over CPI inflation of the spending rate and investment expense
secondary: to outperform a policy benchmark
AA: lower risk tolerance than endowment due to higher liquidity requirement
main mission/features
- non-proft institutions set up to make grants to support specific charitable causes
- to maintain PPP in perpetuity and earn returns sufficient to support the grant-making activities of the foundation
liabilities and inv. horizon:
- typically have a perpetual inv. horizon
- legally required to spend 5% of asset
- the higher liquidity requirements of foundation imply a lower risk tolerance than university endowment
Banks
liquidity: regulatory require banks to have sufficiently liquid assets to cover near-term expense, cash outflows, and to have adequate level of capital from stable sources
primary function:
earn profits by taking deposit from savers and making loans to borrowers
ST liabilities are deposit from customers
LT : debt
inv. horizon is influenced by the difference between the LT liquid assets and the ST liquid liabilities
Insurers
liquidity needs affect by level of int. rates
life insurer
long duration liability
property & casualty insurer
short duration higher uncertainty
change in equity capital
bank & insurer b/s management
change % E = % change a(m) - % change L (m-1)
m = A/E leverage multiple
De = Da(M) - Dl(M-1) * change in I/change in y
Da = MD of asset
change in i/ change in y increase estimate change in yld of liabilities
relative to a unit change in yld of asset ,y
Std e ^2 = M^2 * STDa^2
+(M-1)^2STDl ^2
- 2M(M-1)stdA* stdL * correlation (A,L)
Std decrease
hold diversified FI
hold high quality FI
hold more liquid instrumetn
erase std L
surrender penalties
predictability of underwriting loss
diversifying insurance business
derivatives transparency and collateralizatin
increase correlation
maintain similar duration for A/L
prepayment penalties of bonds
variable annuities
hold common stock
