Reading 4.1

Question 1

Endowment funds are funds established by ____ that invest ___ and use the invested capital to support the activities of an organization (e.g., university, church, or hospital).

Endowment funds have long investment horizons and are not heavily regulated in terms of investment activities, so they can use a ____ .

Answer 1

not-for-profit entities

supporters’ charitable contributions

broad universe of assets (including alternative assets)

Question 2

Foundations raise funds through ____ and use the capital to fund ____.

Like endowment funds, foundations can use a broad universe of assets due
their ____.

To take advantage of beneficial tax treatments, foundations must ___

Answer 2

charitable contributions

grants and support charities

long investment horizons and light regulation

distribute a minimum percentage of their assets each year

Question 3

four types of pension funds:

Answer 3

1) National pension funds: managed by governments and have broad investment possibilities

2) Private defined benefit funds: provide pension benefits to private companies’ employees. The employees are promised a specific retirement income based on a number of factors (e.g., years of employment, age, and salary), which may include provisions for change (e.g., cost-of-living adjustments or retirement income being paid to surviving family members).

3) Private defined contribution funds: These funds receive contributions for employees from the plan sponsors. Each beneficiary’s assets are managed by the plan sponsor and the employee: the sponsor decides on the list of available asset classes and fund products, and the employee selects the asset allocation. When employees retire, they are given the value of their accounts.

• In contrast to national and defined benefit funds, these pension funds do not typically have access to all alternative assets (due to government regulation and the illiquidity and lumpiness of alternatives; in addition, most employees’ net worth is less than that required to invest in alternative funds).

4) Individually managed retirement accounts (mostly for self employed or investors) - similar to private savings plans in that employees manage the assets. Accounts are subject to regulation (due to tax advantages), so the universe of available asset classes is limited (with alternative investments typically not being available).

Question 4

The growth of SWFs (especially in emerging markets) is linked to

Answer 4

increases in prices of natural resources (e.g., oil and gold)

Question 5

The 4 main decisions in the institutional investment process include:

Answer 5

1) strategic asset allocation (SAA)- creates a portfolio allocation for the asset owner with the optimal risk-return balance over a long investment horizon & used as a benchmark of performance
2) fund selection
3) method of diversification
4) liquidity management

Question 6

SAA is based on ____, ____ relationships that are ____ and modifying the ____ to reflect current, fundamental economic changes

Answer 6

long-term

historical risk-return

expected to persist in the future under normal conditions

historical relationships

Question 7

Expected return on asset classes may be expressed as the sum of 3 components:

Answer 7

Asset class return = Short-term real risk-free rate + Expected inflation + Risk premium

Question 8

Estimating long-term returns on alternative assets may be more challenging for 3 reasons:

Answer 8

1. ACCURATELY ESTIMATING RISK AND RISK PREMIUMS IS DIFFICULT since many alternative asset classes (e.g., hedge funds and private equity) lack an adequately long history,
2. ALPHA IS EXPECTED TO DECREASE IN THE FUTURE: Since alpha tends to decrease when competition and allocation increase, the same amount of alpha may not be available in the future if allocations to alternative assets increase.
3. NEW ASSETS ARISE: Since the alternative investment industry regularly introduces new assets in response to changing economic conditions, the role and returns of these assets in investors’ strategic asset allocations are unknown.

Question 9

The appropriate allocation (SAA) cannot be determined for Alternative Assets using standard risk-return optimization models for 3 reasons:

Answer 9

1) Estimating risk premium and correlations with other asset classes is challenging.

2) Analyzing correlations between asset classes may not be possible without making strict assumptions.

3) Some asset classes are lumpy (indivisible), and desirable investments may be unavailable when asset allocators are constructing optimal portfolios.

Question 10

Due to the lack of available information, investors generally construct portfolios using 2 approaches:

Answer 10

1) naive approaches
2) combination of quantitative optimization and naive approaches

Question 11

Some institutions cap their allocations to various asset classes at ___; while larger, more experienced institutions may have allocations that exceed __%.

Answer 11

5-10% and 30%

Question 12

3 REASONS FOR PLACING CAPS & FLOORS ON ASSET ALLOCATIONS

Answer 12

1. Absolute size of allocation
   * If the allocation is too small, putting together a dedicated team needed to generate superior returns will be challenging.
   * If the allocation is too large, finding enough investment opportunities may be difficult or investments may be made in lower-quality opportunities, resulting in lower returns.
2. Relative size of allocation with respect to overall portfolio
   * If the allocation is too small relative to the overall portfolio, it will not have a large enough effect on the overall portfolio (i.e., it will not “move the needle”).
   * If the allocation is relatively large, investors may be under-diversified and overexposed to risks associated with the asset class.
3. Liquidity needs
   * The allocation should consider the liquidity that the institution needs to support its business, which is particularly important for endowments and foundations. The lower the ongoing liquidity needs and the higher the excess capital, the more funds can be allocated to illiquid asset classes such as private equity. More mature private equity programs generally generate more liquidity, which provides more funds to allocate to private equity

Question 13

What is an OBJECTIVE for asset owners?

Answer 13

It is a preference that differentiates between an optimal and a suboptimal solution.

Asset owners should clearly state their investment objectives in terms of risks and returns that are consistent with their risk tolerance levels and current market conditions. In addition, objectives need to be consistent with the fact that higher returns are associated with higher levels of risk.

Question 14

What is a constraint?

Answer 14

constraint is a condition that must be satisfied by any solution.

Question 15

Describe an internal and external constraint

Answer 15

1) Internal constraints - imposed by asset owners based on their specific needs and may depend on factors such as the owner’s time horizon, liquidity needs, and desire to avoid certain sectors.

2) External constraints are driven by factors that are not controlled by asset owners; they come from market conditions and regulations. For instance, asset owners may be prohibited from investing in certain assets, or fees and due diligence costs may prevent an asset owner from considering all asset classes.

Question 16

THREE INTERNAL CONSTRAINTS

Answer 16

1. Liquidity
   * Asset owners and portfolio managers may demand certain liquidity levels by imposing minimum investment requirements for cash and other liquid investments (e.g., to cover expected cash outflows), and by imposing maximum investment levels for illiquid assets (e.g., private equity).
2. Time horizon (can affect their liquidity needs & asset allocation decisions)
   ► Investors with short time horizons may impose maximum limits on risky allocations or change their risk aversion degrees to accommodate the short time horizons and provide themselves adequate time to recoup significant losses.
   ► These investors may also impose maximum limits on allocations to commodities since they will not be able to benefit from commodities’ long-run mean reversion.
3. Country and sector limits
   * Asset owners may impose constraints on allocations to certain countries or sectors. For instance, pension plans may be prohibited from investing in certain countries, or a charitable foundation may be prohibited from investing in certain industries. While adhering to asset owners’ constraints, portfolio managers should present different allocations with variations of the constraints so that asset owners can appreciate potential costs associated with their constraints.

Question 17

TWO EXTERNAL CONSTRAINTS

Answer 17

1. Regulation
   * Regulations are imposed on investment strategies of some institutional investors. For instance, many pension funds are required to limit their allocations to certain asset classes.
   ► The Employee Retirement Income Security Act (ERISA) regulates management of private pension funds in the U.S., and the Financial Conduct Authority establishes regulations for pension funds in the UK.
2. Tax status
   * Most institutional investors are tax exempt, therefore optimization techniques should not allocate to tax-exempt instruments since the instruments have low returns and are no benefit to the tax-exempt investors.
   * Family offices and high-net-worth investors are not tax exempt, therefore optimization techniques should incorporate the effect of taxes. For instance, constraints can be imposed to sell unprofitable investments to offset gains from profitable investments.

Question 18

What is an investment policy statement (IPS)

Answer 18

It is an investor-specific document that describes an investment program’s main goals and provides a framework to achieve those goals. As such, it serves as a roadmap for asset owners and their advisers and investment managers.

Question 19

6 WAYS A THOUGHTFULLY DEVELOPED IPS supports an investor:

Answer 19

1. OUTLINE OBJECTIVES: Articulating the investor’s long-term investment objectives and outlining policies and procedures to help meet those objectives.
2. DETERMINE RISK TOLERANCE: Providing guidance around the investor’s and governing bodies’ risk tolerance and investment beliefs.
3. MONITOR: Monitoring the investment program and measuring outcomes against objectives.
4. SUPPORT STAFF: Helping new staff, board, and investment/ finance committee members get informed on the investments.
5. STRATEGIC OVERVIEW OF INVESTMENT PROGRAM: Enabling the investor to focus on important strategic issues and taking a holistic view of how the investment program connects to goals and activities.
6. ROADMAP FOR FIDUCIARIES: Serving as a road map for fiduciaries and providing guidance through all phases of a market cycle

Question 20

There is no standard IPS; they vary across ___. They are typically composed of _ to at least __ pages, but the specific structure and content is driven by many factors, including the investor’s ____, ____ and ____, _____, and ___ of the portfolio.

Answer 20

investor

2 - 50

governance structure

depth of internal resources

expertise

investment philosophy

complexity

Question 21

First Section of the IPS includes which 3 elements?

Answer 21

1) description of the asset owner - brief overview of the investor and describes its mission

2) purpose & scope of the IPS - overview and sets the tone for guidelines in the
document. It also states the relevant asset pool(s); particularly important when an organization has multiple asset pools.

3) REFERENCE TO APPROPRIATE FIDUCIARY STANDARDS that drive the principles and guidelines in the document, and makes reference to appropriate laws. Includes referencing the fiduciary standard of “reasonable care, skill and caution of a prudent investor” and the notion that investment decisions should be assessed in the context of the entire portfolio and overall investment strategy, not in isolation.

Question 22

5 key decision making parties in the ROLES AND RESPONSIBILITIES part of an IPS

Answer 22

1. BOARD (highest governing body (e.g., board of trustees) is typically responsible for approving the IPS and target asset allocation strategy, and periodically reviews the investment program to confirm that the portfolio is meeting the objectives stated in the IPS. The IPS should state the areas in which the board wants to RETAIN DECISION-MAKING AUTHORITY.
2. Investment committee (or a finance committee) - typically delegated by the board the role of making recommendations or final decisions.
3. Internal staff- responsible for daily activities and overseeing the investments.

Some asset owners have dedicated internal investment staff (e.g., chief investment officer) with higher levels of responsibility (e.g., implementing tactical allocation decisions); others have few or no internal staff and may delegate responsibilities to the chief financial officer and finance department.

4. Investment adviser(s) and/ or outsourced chief investment officer (OCIO) - responsibilities may include frequency of communications, key deliverables, and acknowledgement of fiduciary responsibilities. Stating these helps to manage expectations on both sides.
   * The level of discretion (and fiduciary responsibility) of OCIOs is considerably greater and may include hiring and firing managers and changing asset allocations.
5. Trustee/custodian (or other external providers) - Key external providers’ (e.g., the custodian) duties, expectations, and fiduciary responsibilities should be acknowledged.

Question 23

2 characteristics of Investment objectives:

Answer 23

They should be:
1) realistic (i.e., attainable)
2) consistent with the organization’s mission

Question 24

Investment objectives are typically stated as

Answer 24

absolute return targets

These targets should be linked to the organization’s goals (e.g., “real return of 6% relative to CPI to support the endowment’s long-term spending needs” or “3% return over plan liabilities”);

Question 25

What are the common investment objective of: endowments & foundations, pension funds, SWF and family offices

Answer 25

1) endowments & foundations (mostly long term invest horizon): return target of x% above inflation, connected to long-term spending needs (to maintain purchasing power and support the organization’s spending needs).

2) Pension Funds (Objectives are tied to the sponsor’s responsibilities to the plan beneficiaries and differ based on type of fund) - return target of x%
above the liability discount rate, to meet retirement distributions

3) SWF - long-term investors with objectives that depend on the type of fund (e.g., stabilization, reserve, savings, and development funds).

4) Family offices: vary depending on the family’s goals or needs, which may range from preserving wealth for the next generation to focusing on philanthropy. Objectives may often be framed as with endowments (e.g. long-term real growth to support current and future spending needs).

Question 26

What are the common investment horizons of: endowments & foundations, pension funds, SWF and family offices

Answer 26

1) endowments & foundations (mostly long term invest horizon): 10+ years

2) Pension Funds - driven by their funded status, duration of liabilities,
and whether the plans are open, closed, or frozen.

3) SWF - differ based on objectives and near term spending needs

4) Family offices: differ based on objectives and near term spending needs

Question 27

Asset owners with more complex investment programs may have risk management policies that define policies related to specific areas of risk.

Give 3 examples:

Answer 27

foreign currency / overlay strategies / liquidity, and operational

Question 28

What is the purpose of a SPENDING POLICY in IPS?

Answer 28

Sets the expectation of cashflow needs for the asset owner

Question 29

Spending policies are often stated in terms of

Answer 29

a fixed spending rate of x% of the portfolio’s moving average market value over a trailing period of y quarters.

Some asset owners may have a more flexible spending policy of 0% to a maximum of x%.

Question 30

How do spending policies vary depending on the asset owner: endowments & foundations, pension funds, SWF and family offices

Answer 30

1) endowments & foundations: common especially with mandated distributions

2) Pension Funds - not always applicable

3) SWF - may have no short-term spending plans, but have the ability to
draw on funds when required.

4) Family offices: may serve as protection for future generations by controlling
distributions to the current generation.

Question 31

Why is it recommended that institutional investors set flexible targets and ranges for broad asset categories instead of rigid targets for specific asset classes?

Answer 31

This allows for more dynamic portfolio management while still providing clear guidelines for implementation and monitoring.

Question 32

An IPS should include general criteria for selection and retention of investment managers. The decision to select and retain managers should be driven by several factors:

Answer 32

• PERFORMANCE: long-term performance versus benchmarks and peers,
• INVESTMENT CONSISTENCY consistency of investment style,
• TEAM STABILITY stability of the team and firm.

Question 33

An investment’s purpose also varies depending on the asset owners and their objectives.

Answer 33

1) endowments and foundations are likely to invest in fixed income for
diversification benefits and return premiums, while many pension plans allocate to fixed income to hedge liabilities.

2) A family office with concentrated holdings related to the family business may invest in strategies that hedge their concentrated exposure.

3) A sovereign wealth development fund may focus their private equity and infrastructure investments on local industries aimed at growing productivity and increasing the country’s future wealth.)

Question 34

What is the purpose of a STRATEGIC INVESTMENT GUIDELINE in an IPS?

Answer 34

Provides a framework for evaluating allocation choices across asset classes and investment strategies to achieve the portfolio’s objectives. It also provides guidance for staff and fiduciaries conducting manager due diligence and implementing rebalancing and tactical asset allocation

Question 35

How is the performance of a portfolio and manager evaluated in an IPS?

Answer 35

Benchmarks are used to evaluate performance

• Total portfolio performance should be evaluated based on a weighted benchmark consisting of broad market indices aligned with the strategic allocation targets
• Performance of underlying managers should be compared using an appropriate market index specific to each strategy or using peer groups

Question 36

4 ADDITIONAL CONSIDERATIONS IN AN IPS

Answer 36

1) responsible investing (ESG)

2) Proxy voting

3) Brokerage and other investment-related expenses
* Asset owners typically include a statement about investment-related expenses, acknowledging that investment managers have discretion to select brokers and negotiate commissions, but requiring them to seek “best execution” services.

4) Liquidity policy