Portfolio Management Strategies 12- Liability Driven Investing for Flashcards
What does a aliability-driven investing (LDI)
approach focus on?
It focuses on managing plan assets in a way that best meets the present and future values of liabilities
What is the equation of an LDI portfolio?
Market Value of Plan Assets – Present Value of Plan Liabilities = Funding Status
What is the definition of market value of plan assets?
it is the value of a company according to the stock market
What is the definition of present value of plan liabilities?
It is an estimation of future liability at a discounted rate
What is a funding status?
It is a residual of all asset and liability interactions, as the relevant “portfolio” to be managed
What are risk factors that the LDI approach reduces?
quity risk, interest-rate risk, credit-risk spread, inflation risk, yield curve slope risk, and a range of factors affecting security performance
What is a funding ratio?
It reflects a pension fund’s current financial position, expressing the ratio between available assets and liabilities
What are two important indicators of how well a plan is managed?
low surplus volatility and an increase in the funding ratio
Why are these two indicators important?
Long-run returns with high short-term volatility result in short-run contributions to the plan that are not recoverable later when the return performance recovers
Do lower interest rates make the present value of liabilities
higher?
yes, because the discount rate is an important factor in the present value of outflows calculation. A combination of underfunding and investments in securities that fall in value when interest rates fall make the plan performance riskier.
Why is the funding ratio important?
The risks in the liabilities play a larger role in an unfunded status
Why is the funding ratio important?
The risks in the liabilities play a larger role in an unfunded status
To offset the recent (and expected) modest performance
of stocks and bonds, planned assets must _______.
include a wider array of securities, since plan returns and volatility from stock and bond contributions are not sufficient to improve funding ratios
Real assets tend to be _______ to inflation
because of their tangible nature.
(sensitive or insensitve)
sensitive
What are examples of real assets?
- direct investment in real estate
- commodities
- precious metals
- timber
- energy
- farm-land
- commodity-linked stocks
- commodity-linked hedge funds
What do real assets do for an LDI platform?
They provide potential reductions in surplus volatility to the extent that real asset movements are not highly correlated tomovements of financial assets.
What does inflation do for an LDI platform?
Real assets generally appreciate with inflation while inflation
directly drives interest rates higher and financial assets lower. Returns from real assets also may boost returns, because
real assets may not be as efficiently priced as the more competitively priced stocks and bonds.
Why are real assets considered attractive?
There tends to be much less diversification potential from combining assets within an asset class than from combining assets from different asset classes.Real assets represent such a broad asset class that a wide range of correlations exists both within the asset class and with assets from other asset classes, allowing for attractive diversification.
What is an asset class?
A group of assets that have high correlations with each other but have low correlations with other groups of assets
What is a dynamic approach?
It varies the size and composition of hedge assets in response to economic and market factors in an effort to improve outcomes
Correlations ____ stable in the short run and surplus volatility must be actiively managed with prompt and pre-planned responses.
(are or are not
are not
What are the two views investors behave like?
Rational view and behavioral view
What is a rational view?
It focuses on maximizing wealtg and is low risk-taking
- hold well diversified “efficient” portfolios
- incorporate all available information
- only “fundamentals” matter
What is a behavioral (psychogiy) view?
- individuals suffer from biases and misperceptions
- don’t always incorporate relevant information
- sometimes base decisions on “non-fundamental” emotions
What is behavioral finance?
it attempts to ecplain financial market behavior using results from experimental psychology- how market prices are effected when investors do not behave “rationally”
What does the efficient market hypothesis (EMH) explain?
It doesn’t say that all investors are rational. It says
What does market efficiency mean?
security prices are right meaning they fully reflect all available information
What does “there is no free lunch” explain?
- the only way you can get higher retuirns is by taking on more risk
- there is no information out there that can be used to construct strategies that earn returns higher than required for their risk
What is a joint hypothesis problem?
Any rejection of a model of the risk premium and market efficiency means
LDI takes into account the need to fund future liabilities and make sense if future liabilities are _______________.
predictable.
Examples of liability-driven investors:
Defined benefit pension fund
Insurance company
AN individual retiree
