Institutional Investors Flashcards
5 Differences of Institutional Investors
- Scale (size) suitable allocation and diversification for large aum. A benefit accessing wider investment universes.
- Long time horizon than individuals with lower liquidity needs.
- Regulatory framework - different legal, regulatory and tax rules.
- Governance framework - formal governence structures with a board of directors and investment committee.
- Principal-agent issues - Principal is the owner of the asset. Agent is appointed by the principal. Interests may align differently.
Institutional IPS should include
General outline
The institution’s mission and investment objectives (i.e., return and risk tolerance).
Discussion of the investment horizon and liabilities that need to be paid by the institution.
External constraints that affect the asset allocation (legal, regulatory, tax, and accounting).
An asset allocation policy (i.e., portfolio weights) with ranges and asset class benchmarks.
A rebalancing policy.
Reporting requirements.
General outline:
The main features/mission of the institution.
The stakeholders (i.e., parties impacted by the success/failure of the institution).
The key elements of the IPS, usually in the following order:
Liabilities and investment horizon.
Liquidity needs.
External constraints.
Investment objectives.
Asset allocation.
4 Model approaches to asset allocation 2 positives and 2 negatives internal/external management?
Norways sovereign wealth fund
Endowment model
Yale Endowment University endowment
Canada pension plan
Liability driven
Norways sovereign wealth fund: passively managed to public equities and bonds (60/40 split). Little alternatives exposure, tracking error limits.
+low costs and fees
+transparent holdings
+easy for board to understand
- no opporunity for value add and outperformance
Endowment model uses external management, has high allocation to alternatives, active management, long time horizon, high risk tolerance and low liquidity needs.
+ More possibility for value added above market returns.
- More expensive and difficult to manage for smaller investors.
Yale University endowment: high allocation to alternatives, significant active management, END/EXTERNALLY MANAGED assets.
+potential for outperformance
- difficult for small institutions without expertise in alternatives
-higher fees and costs
Canada pension plan: (endowment but internal management) High allocation to alternatives, significant active management, INTERNALLY MANAGED assets.
+ potential for outperformance of markets and development of internal capabilities.
- Potentially expensive and difficult to manage.
Liability driven: DB funds Focus on hedging liabilities with duration matched fixed income exposure. ‘Maximising expected surplus (assets - liabilities) return’ and managing surplus volatility.
+ Explicitly recognises liabilities of investment process usually consists of long duration fixed income and swaps.
- certain risk of liabilities are difficult to hedge such as longevity risk.
Factors that increase Pension plan ability to take risk
- Young workforce with more active lives (old and high retired lives reduces risk tolerance)
- No provision for early retirement or lump sum distributions (this would lower risk tolerance if provided)
- Lower debt ratios and higher expected profitability
- Lower correlation of sponsor operating results and pension asset returns.
- Large sponsor company size relative to pension plan.
- Surplus funded status.
DC Pension
participant-switching options,
participant/cohort option,
Many DC plans offer a default life-cycle option (also called target date option) where asset mix is managed according to a desired retirement date. These life-cycle options can be either participant-switching options, which automatically switch members to a more conservative asset allocation as they age, or a
participant/cohort option, which involves pooling the participant with other investors with a similar retirement date ie 2020 employee plans to retire in 25 years would invest in a fund with target date of 2045 with the fund being managed more conservatively as the retirement date is approached.
5 types of SWF defined by the IMF purpose and allocation:
- Budget stabilization funds.
- Development funds.
- Savings funds.
- Reserve funds.
- Pension reserve funds.
- Budget stabilization funds. These are set up when a nation’s revenues are heavily linked to a natural resource. So avoids cyclical assets whose returns are highly correlated to main sources of government revenue. Short horizon. Highest liquidity needs.Capital preservation. Aims to earn returns above inflation with a low probability of losses. The majority of FIXED INCOME and CASH is due to the defensive nature of the fund.
- Development funds. This investment prioritizes national socioeconomic projects, usually infrastructure. Long horizon, low liquidity needs. Implicit objective is to earn a real rate of return greater than real domestic GDP.
- Savings funds. These funds invest revenues from nonrenewable assets for the benefit of future generations. Main objective to grow wealth for future generations. Long term. Lowest liquidity needs. A long investment horizon means relatively high allocations toward equities and alternative investments, such as private equity and real assets.
- Reserve funds. These are designed to earn returns on excess foreign reserves held by central banks reducing NEGATIVE CARRY costs. Typically, foreign exchange reserves held by central banks are low-yielding assets relative to the yields offered by bonds issued by central banks that make up their liabilities. Reserve funds aim to reduce this negative cost of carry through boosting returns on reserves. Very long horizon. Liquid bonds held AND 50%-70% in equity to offset high allocation in bonds and high yield. Earn a rate of return in excess of the yield the government/central bank pays on bonds it has issued. Allocations are similar to those of savings funds, but with lower allocation to alternatives due to the potentially higher liquidity needs.
- Pension reserve funds. These are used to save and invest to meet future pension and health care liabilities of governments. Accumulaiton phase low liquidity needs (contibutions). Decumulation phase higher liquidity needs (benefits drawn). These have HIGH ALLOCATION TO EQUITY and alternatives due to a long investment horizon and low liquidity needs in the accumulation phase.
International Forum of SWFs
Tax treatment of SWFs
In order to avoid political influence, high-quality governance, independence, transparency, and accountability are crucial. The Santiago Principles, a best-practices framework established by the International Forum of SWFs (IFSWF), addresses such concerns. SWFs are generally tax exempt.
University Endowments
Liquidity and time horizons?
Tax treatments of contributions and withdrawals.
Asset allocation
Objective?
D3
Key comment: University endowments: Aims to maintain purchasing power in perpetuity along with achieving investment returns to support the budget.
Funds set up by gifts and donations, which are invested to earn returns that provide ongoing support to the university’s operating budget. the endowment’s annual spending net of gifts and donations is usually very low (around 2% to 4% of assets). Low liquidity needs plus the perpetual time (LONG TERM) horizon mean endowments usually have a high risk tolerance.
Endowments typically have tax-exempt status when generating investment returns. Universities are not typically taxed on payouts from the endowment, and donors to endowments usually can deduct gifts from their taxable income.
Their primary aim is to beat inflation , which involves a majority (>50%) allocation to alternative investments, an allocation that has increased over the past two decades
The objective is to meet the annual spending level of the operating budget ie 5%. The nominal required rate of the return would be the annual payment plus HEPI (Higher Education Price Index)
Private Foundations
Main objective
Risk tolerance and liquidity vs an endowment?
Time horizon vs endowment?
Foundations are nonprofit institutions set up to make grants to support specified charitable causes.
The main objective of private foundations is typically to maintain purchasing power in perpetuity (LONG TERM) or sometime LIMITED Life. Foundations differ to endowments in two ways: they are legally required to pay 5% in order to achieve tax exempt status (costs of running the foundation are included in this) AND earn returns sufficient to support the ENTIRE budget of their organisation.
Foundations have a lower risk tolerance than university endowments due to higher liquidity requirements and the heavy reliance on the foundation’s spending. However, their overall risk tolerance remains high and, with a long-term objective of beating inflation, larger U.S. foundations allocate about half of the portfolio to alternative investments.
Donations must be spent in the year received which lowers risk tolerance compared to endowments.
Foundations may issue bonds which leads to a higher risk tolerance.
In general foundations have high risk tolerance with short term liquidity needs where endowments have high risk tolerance with low liquidity needs. (Foundation lower risk than endowments)
Time horizon is very long term/perpetual vs endowments perpetual.
Banks
Liquidity
SIFI
3 accountancy perspectives
Deposits are short duration liabilities so liquditiy management is key. Due to liquidity coverage ratios and net stable funding raitos (NSFRs), banks need more liquidity. Capital adequacy is key plus leverage levels.
Higher reserves should be held for riskier books of business.
SIFI = Significantly Important Financial Institutions capable o f systemic risk. Require increased capital to absorb losses. They have derivative restriction use. Increased capital required to absorb losses.
Accountancy 1. Standard financial reporting (GAAP or IFRS) to communicate to shareholders. 2. Statutory accounting used by regulators on a more ocnservative measure. 3. True economic accounting uses market value of all assets and liabilities so more volatile.
Insurers
Life and P&C
Life insurers. They write insurance relating to whole life or term insurance with fixed payments, variable life insurance (with payouts linked to returns of investment funds chosen by the policyholder), annuity products, health insurance, and universal life insurance (with flexible premiums and benefit payouts). Long duration with more certainty.
Property and casualty (P&C) insurers. They write insurance relating to commercial property and liability, home ownership, marine insurance, surety, and legal liabilities. Short duration and higher uncertainty so more liquidity required.
Either publicly listed companies or mutual companies. Mutual companies are owned by their policyholders.
Insurers divide general account investments into two major components: Reserve portfolio (capable of meeting liabilities) and surplus portfolio. (higher returns)
US regs ‘National Association of Insurance Commissioners (NAIC) set accounting and reporting policies.
Europe ‘Solvency II’ is a framework used to standardise regulation across member states.
What are the main Insurance regulators.
Bank and insurance capital requirements require what type of reporting?
US regs ‘National Association of Insurance Commissioners (NAIC) set accounting and reporting policies.
Europe ‘Solvency II’ is a framework used to standardise regulation across member states.
‘STATUTORY REPORTING’ is required by regulators, which involves a series of adjustments to standard financial reporting that remove low-quality assets and accelerate certain expenses in order to set the level of required reserves.
Pension fund liquidity and risk is altered how by retired lives?
A low proportion or retired lives allows for greater risk tolerance and lower liquidity needs. (High retired lives would need more certainty and liquidity)
DB Schemes key points to cover
- Summary
- Stakeholders
- Investment Objectives = Return is for Plan assets to exceed PBO or Risk = minimise cash contribution
- Liabilities
- Liquidity needs
- Time horizon
- Regulation/Tax
- Asset allocation
Liabilities effect from a higher:
Service years
Salary
Longevity
Vesting
Discount rate
Additional contributions
Investment returns
Service years = Higher PBO as people work longer
Salary = Higher PBO as payments will be more at the end of career
Longevity = Higher PBO due to paying people longer
Vesting = Higher PBO due to people working longer expecting a larger pension payment.
Discount rate = Lower PBO due to a lower liability figure from discounting at higher rates.
Additional/matching contributions = Higher PBO due to higher employer contributions.
Investment returns = Lower PBO due to higher discount rates
Plan sponsors prefer a higher discount rate to make liabilities appear smaller. Conversely beneficiaries would prefer a lower discount rate as this would force the plan sponsor to contribute more. So long as the sponsor can remain solvent.
