Portfolio Management for Institutional Investors Flashcards
What are the five defining characteristics of an institutional investor?
- Scale
- Long horizon
- Regulatory Frameworks
- Governance Frameworks
- Principal-Agent Issues
What issues scale issues to very large institutional investors face?
It becomes difficult to allocate to allocate as much capital as desired. For example, an allocation to a hedge fund may result in the investor holding large amounts of the fund. This applies to VC as well. Some active managers cannot handle the large amounts of money and still deliver alpha. They will also face issues in moving the markets when trading in certain asset classes.
What is a typical example of a principal agent problem in institutional investing?
When funds have a high base fee that does not depend on performance, there is little incentive to deliver higher returns.
How does investment governance framework affect the ability of institutional investors to allocate towards different asset classes?
II rely on many different parties for expertise. If an investment team does not have the relevant expertise, then it will be difficult to complete due diligence and allocate to complex investment strategies.
What is the Norway model? What are the pros and cons?
The Norway model involves traditional 60-40 management using largely passive investments. There is tight tracking error and the benchmark is typically the starting point. Pros: 1) Low cost 2) Very transparent 3) Suitable for a large scale 4) Easy to understand Cons: 1) Little opportunity to add value through active management
What is the Endowment model? What are the pros and cons?
The endowment model is characterized by high exposure to alternative investments, active management, and outsourcing.
Pros:
1) High potential value add
Cons:
1) Expensive and difficult to implement for very large funds
What is the Canada model? What are the pros and cons?
The Canada model is characterized by high exposure to alternatives, active management, and insourcing.
Pros:
1) High potential of value add
2) Development of internal capabilities
Cons:
1) Potentially expensive and difficult to manage
What is the LDI model? What are the pros and cons?
The LDI model is characterized by a focus on hedging liabilities and interest rate risk. There is often a hedging and return seeking portfolio.
Pros:
1) Recognizes liabilities in the investment approach
2) Other risks will go unhedged
What are the factors affecting the calculation of defined benefit liabilities?
- Service/Tenure - more years = more pay
- Salary - higher growth bigger benefits
- Matching/additions - more matching, higher liability
- Mortality assumptions - live longer, higher liability
- Expected vesting - more vesting means more obligation
- Expected returns - in some cases, higher expect returns will increase the discount rate used
- Discount rate
What are the key factors affecting the risk tolerance and objectives of DBPP?
- Plan Status - higher funded status implies a potentially greater risk tolerance
- Sponsor financial status measures by D/A, expected profitability, and size of plan compared to company - better financial position and higher relative size of company is supportive of a higher risk tolerance
- Sponsor and pension common risk exposures - the lower the correlation between sponsor results and pension returns, the higher the risk tolerance
- Plan features - provisions for early retirement reduce risk tolerance as they reduce the duration of liabilities.
- Workforce characteristics - the younger the workforce and greater portion of active members, the higher the risk tolerance.
What are the typical types of sovereign wealth funds?
- Budget stabilization funds
- Development funds - socio-economic projects, infrastructure
- Savings funds
- Reserve funds
- Pension reserves
What are the 3 types of endowment spending rules?
- Constant Growth - this is when the endowment provides a fixed amount adjusted for the HEPI, possibly with a spread. Not good in a negative return environment, so usually puts caps and floors.
- Market Value Rule - this shows a spending rate as a % of the moving average of asset values. This is procyclical (disadvantage?)
- Hybrid rule is a weighted average of both
What is the basic template for an endowment investment objective?
The objective is to generate sufficient returns to preserve the purchasing power of the fund after inflation and grow the value of the fund over time. Primary objective to achieve a total real rate of return of X% with an expected volatility of Y% over K years. Secondary and tertiary objective include beating other endowments or benchmarks.
What is the basic template for a foundation investment objective?
The primary investment objective it typically to generate 5% total real return over the CPI, plus investment expenses, over a 3-5 year period, with reasonable volatility (10-15% SD)
Who are the primary stakeholders of banks?
- Shareholders
- Creditors
- Customers
- Credit Rating Agencies
- Regulators
- Employees
- BOD
