Investments

Question 1

Process of setting an investment strategy

Answer 1

1. Choose a baseline allocation to the main asset classes.
2. Choose a legal form in which to hold the assets.
3. Determine the investment style and investment managers.
4. Determine the mandate and flexibility (freedom of managers) of each asset.
5. Choose custodians, brokers, and investment consultants where appropriate.

Question 2

Different types of investment strategies

Answer 2

• Liability-driven investment (LDI): investment strategy is based on the liabilities as a benchmark - try match as much as possible.
• Active management: assets and underlying securities are selected individually through an active process with the aim of outperforming a benchmark. Can use growth (start-ups), value (companies close to or below intrinsic value), income (high dividend payouts), momentum (invest in over performing) strategy
• Passive management: investment in funds that track an index or exchange traded funds (ETF), usually at much lower cost than active management.
• Implemented consulting: investment consultants are given limited authority to implement investment decisions, instead of providing advice only.
• Fiduciary management: investment consultants are given full authority to make and implement investment decisions

Question 3

Different stakeholders involved in investment strategy

Answer 3

• custodian: holds title for assets, and provides protection if investment manager flees with asset proceeds or defaults e.g. bank
• investment manager: tells brokers how to invest money and what trades to do.
• broker: executes the trades, chosen by investment manage
• investment consultant: helps beneficial owner to determine how to allocate assets, what vehicle assets should be held in, which investment managers to choose and what mandates to give these managers

Question 4

Different asset models

Answer 4

1. Random walks - lots of volatility and past cannot be used to predict the future
2. Autoregressive models - volatile in short term but longer term has more stable view on returns
3. Regime switching - there are states of volatility and state of stability
4. Arbitrage models

Question 4

Immunisation

Answer 4

• used when perfect matching cannot be achieved but protects against interest rate movement
• best for guaranteed liabilities
• impractical as involves constant rebalancing of portfolio as interest rate moves
• following conditions need to be met:
  > PV (liability outgo) = PV (asset proceeds)
  > DMT (liability outgo) = DMT (assets income)
  > spread about the mean term of the value of the asset proceeds is greater than the spread of the value of the liability outgo.

Question 5

Different ways to model mortality

Answer 5

1. Lee Carter model - mortality probability modelled using lognormal model
2. CBD model - mortality probability + rate at which mortality probability changes due to age modelled using bivariate lognormal model
3. cohort model - different generations are expected to have different mortality behaviour

Question 6

Considerations when choosing investment strategy of DB fund

Answer 6

• the purpose would be to ensure that DB are paid with highest probability and lowest amount of risk
• consider the liability profile of the DB - nature, currency, term (long-term)
• level of assets available i.e. funding level, dictates the risk appetite
• consider tax and regulation impact
• consider the costs of investing in different asset classes
• consider the sponsor covenant - less likely to pay benefit = more conservative strategy
• ALM can be used to model the investment strategy
• the investment could be pooled or on an ‘individual basis’ (more a consideration for DC funds actually)