Section 5 - R24 - Portfolio Mgmt for Institutional Investors (Pension Funds, Endowment, Banks) Flashcards
Institutional Investors Common Characteristics (List)
- Scale (small, large, very large)
- Long Term Horizon (long, but for banks short maturity holdings) and Low Liquidity Needs
- Different Regulatory Frameworks (legal, regulatory, tax, accounting)
- Governance Frameworks (BoD, Investment Committee)
- Principal-Agent Issues (interests may be not aligned)
Investment / Implementation Approaches (List)
- Norway Model
- Endowment Model
- Canada Model
- Liability Driven (LDI) Model
Norway Model Inv. Approach (Describe)
Traditional. 60/40 Public Equities + Fixed Income. Mostly passive. Tight Tracking Errors.
Endowment Model Inv. Approach (Description and Suitability)
Yale. High level of Alternative Investments. OUTsourcing.
Suitability: Long Term, Low Liquidity, Skill in Sourcing AI
Pros: High Value-Added Potential
Cons: Expensive
Canada Model Inv. Approach (Description and Suitability)
Active Management. High level of Alternative Investments. Insourcing.
Suitability: Long Term, Low Liquidity
Pros: High Value-Added Potential
Cons: Expensive
Liability Driven Inv. Approach (Description and Suitability)
Focus on hedging liabilities and inetrest rate risk by using duration-matched FI exposure
Suitability: Banks, Insurance Companies
Pros: Recognize liabilities as part of the investment process
Cons: Longevity and Inflation may not be hedged.
Compare Items between DC and DB Pension Funds (List)
DB / DC
1. Benefit Payments (Contractual / Performance)
2. Contributions (Employer / Employee and Employer)
3. Investment Decision Making (Pension Fund / Employee)
4. Investment Risk (Employer / Employee)
5. Mortality and Longevity Risk (No risk to beneficiary / risk to beneficiary)
Pension Fund Stakeholders: Defined Benefit (List)
- Employer (Plan Sponsor: PETROS)
- Employees and Retirees (Beneficiaries)
- CIO and Investment Staff (take decisions)
- Government
- Unions
Pension Fund Stakeholders: Defined Benefit (List)
- Plan Beneficiaries
- Employer (still has fiduciary responsibility as it offers options)
- The Board (select default option)
- Government
DB Liabilities, Assumptions, Objective and Horizon (Description)
Liability: PV Future PMTs (depends: yrs of service, final salary, life expectancy). Adopts LDI in most cases.
Assumptions: (i) wage increase, (ii) expected vesting (iii) life expectancy
Main Objective: Sufficient assets to cover future benefit payments
Funded Ratio = FV Plan Assets / PV Benefit Obligation
Horizon:
- Higher Risk Tolerance
- Volatility of Contributions
- Lower Retired Portion lead to Longer IH
DC Liabilities, Horizon, Liquidity Drivers (Description)
Liability = Contribution (at sponsor level)
Horizon: Each person will be at a different life stage. If low liquidity needs, can hold larger balances in illiquid assets.
Liquidity Drivers:
- % Retired
- Age of Workforce
- Plan Funded Status (Surplus = Accepts less contributions)
- Participant Switching / Withdrawals
External Constraints on Pension Funds (List)
- Legal / Regulatory (Reporting, Transparency, Funding Requirements, Discount Rates)
- Tax and Accounting (Defined Benefit, Defined Contribution)
DB (Petros) Risk Considerations (List and Describe)
- Plan Funded Status: (Ativo - Passivo) = ↓ Funded Status = ↑ Risk Tolerance is necessary
- Sponsor Financial Strength: ↓ Financial Strength (Debt, Profitability) = ↑ Risk to Future Contributions
- Sponsor and Pension Fund Correlation = ↑ Correlation = ↓ Risk Tolerance is necessary
- Plan Design: Provisions (early retirements and lump sum distributions)
- Workforce Characteristics: older, ratio of retirement
Risk Objectives for Pension Funds (Describe)
Risk Objectives may be stated in terms of pension surplus volatility or shortfall. Also may have absolute risk objectives.
Relative Examples:
1: Funded Status > Liabilities
2: Minimize YoY Volatility of Future Contribution Payments
Return Objectives for Pension Funds (Describe)
a. In terms of Future Pension Contributions: zerar futura necessidade de contribuição
b. Pension Income: aumentar PMT de aposentadoria
Differentiate DC and DB Return Objectives (Describe)
1) DC Return Obj: Prudently grow assets to support spending needs of beneficiaries. Outperform benchmark or other DC plans.
2) DB (Petros) Return Obj: Achieve returns that adequately fund its pension obligation (exceed liabilities) on an inflation-adjusted basis.
Pension Fund Asset Classes Possibilities (List)
EFA
- Equities: Growth role, Inflation hedge
- Fixed Income: Defensive role, hedge interest rate risk. May have regulatory minimum
- Alternative Investments: Low or negative correlation with traditional
Sovereign Wealth Types (List)
BD_SRP (São José Rio Preto)
- Budget Stabilitzation Funds
- Development Funds
- Savings Funds
- Reserve Funds
- Pension Reserve Funds
Sovereign Wealth Types (Describe)
- Budget Stabilization Funds: Prevent budget from commodity volatility and external shocks.
- Development Funds: socioeconomic projects, mainly infra
- Savings Funds: share wealth across generations. Transform non-renewable assets into diversified financial assets
- Reserve Funds: Reduce negative carry costs of holding reserves
- Pension Reserve Funds: Meet future outflows (shortfalls)
Sovereign Wealth Funds Stakeholders (List)
- Government
- Citizens
- External Asset Managers
Sovereign Wealth Liabilities (Describe per type of fund)
- Budget Stabilization: Uncertain liabilities. Short IH.
- Development: Uncertain liabilities. Medium to long IH.
- Savings: Long liabilities. Long IH.
- Reserve: Liabilities are the Central Bank monetary stabilization bonds. Long IH.
- Pension Reserve: Liabilities are pension-related. Long IH.
Sovereign Funds Liquidity Needs (List per Type)
- Budget Stabilization: ↑ Liquidity
- Development: ↓ Liquidity
- Savings: ↓ Liquidity
- Reserve: Entre Savings e Budget
- Pension: ↑ need in accumulation or ↓ need in decumulation
Sovereign Wealth Fund External Constraints (List)
LETA
- Legal and Tax: national legislation
- Tax and Accounting: Tax-Free is defined by legislation (not necessarily national)
Sovereign Wealth Funds Investment Objectives (List / Type)
- Budget Stabilization: Capital Preservation. Return > π.
- Development: Real rate of return > real GDP or productivity growth
- Savings: Maintain PP of assets and achieve returns to sustain govt spending
- Reserve: Monetary stabilization. Achieve rate of return above govt stabilization bonds
- Pension: Returns to maximize likelihood of being able to meet future unfunded pension liabilities.
Sovereign Wealth Funds Allocation (List / Type)
- Budget Stabilization: FI & Cash
- Development: Equity, FI, AI
- Savings: Growth Assets (Equities, AI)
- Reserve: Equity, FI, AI ( ↓ Equities / ↑FI )
- Pension: Large Equity, 10-15% AI
Conservative: Budget Stabilization > Reserve > Pension
Return-seeking: Development > Savings
Endowments and Foundations (Describe)
Endowments: Long-Term, Not subject to a specific legally required spending level. Principal must be preserved in perpetuity.
Foundations: Grant-making institutions funded by gifts and investment assets. Tomie Ohtake.
Foundation types: Community (Gerando Falcões), Operating (PUC), Corporate (Fundação Itaú), Private grant-making (Tide Setúbal)
Endowments and Foundations Stakeholders (Describe)
- Current and Future Students (PUC)
- Alumni (PUC)
- Current and Future Faculty Administrators (PUC)
Endowments IH and Liabilities (Describe)
Inv Horizon (IH): Perpetual. FGV and PUC.
Liabilities: PV future payouts to the university based in a spending policy. Target above payout real returns
1) Constant Growth Rate: floor and cap, considering inflation
2) Market Value Rule: % of moving average of asset value (procyclical)
3) Hybrid Rule: weighted avg of 1 and 2. Reduce volatility of spending.
Endowment Spending (Formula)
Spending t+1 = w[Spendingt*(1+π)] + 1-w[Spending rate * AUM]
w = market value rule weight
1-w = constant growth weight
Endowment Return Requirement (Concept)
Since the aim is to maintain purchasing power, target a real return ≥ spending rate
Foundation Investment Horizon and Liabilities (Describe)
Inv Horizon (IH): Very long / Perpetual, except for limited life
Liabilities: US legal requirement of spending 5% of AUM + Investment Fees or pay taxes
- May be able to issue debt
- Rely on their returns
Foundation Main Characteristics (List)
- Required to spend 5% of AUM + Investment Fees or pay taxes
- May be able to issue debt
- Rely on their own returns to support its operating budgets. Hold LESS illiquid assets than endowments.
- Low liquidity needs (net spending of at least 5% of AUM + Inv fees)
External Constraints
Legal and Regulatory: Invest in a Total Return basis
- Exercise duty of care when making investment decisions
Tax and Accounting:
- Gifts/Donations usually tax-deductible for donor investment
- Income tax-exempt
- payouts are tax-exempt if receiving institution is exempt from tax
Endowments v. Foundation Investment Objectives (Differentiate)
Endowments:
1) Maintain PP of assets into perpetuity. Sustain the level of spending necessary to support the university budget.
2) Outperform long-term policy benchmark
3) Outperform peers
Foundation:
1) Generate total return of pi + investment expense with determined volatility for a total specified period
2) Outperform policy benchmark with specified Tracking Error
Endowment Asset Allocation (List)
↓ Size = ↑ FI and ↑ Equity
↑ SIze = ↑ Alternative Investments
Banks Stakeholders (List)
External: Shareholders, Creditors, Customers, Credit Rating Agencies, Regulators
Internal: Employees, Management BoD
Banks Assets and Liabilities (List)
Assets: Loans, Debt Securities
Liabilities: Deposits (Time Deposits = CDB datado, Demand Deposits, short duration), Wholesale Funding
Banks Investment Horizon and Liquidity Need (Describe)
- Perpetual life
- Short to medium duration
- Potential need for increased liquidity (LCR and NSFR)
Insurance Stakeholders (List)
External: Shareholders, Derivative Counterparties, Policyholders, Creditors, Regulators, Rating Agencies
Internal: Employees, Management, BoD
Insurance Liabilities (List)
Life Insurance: Long term. Highly predicatable. One time payout. Subject to mortality risk.
Annuities: Ongoing payouts with shorter durations. Subject to longevity risk.
Property and Casualty: Uncertainty. Inv. Horizon shorter than life. Short duration.
Insurance Liquidity Needs (List)
Life: Disintermediation. ↑ Rates = People terminate insurance policies = ↑ Liquidity Requirements.
Property & Casualty: ↑ Liquidity needs because it is uncertain
Insurance Investment Portfolio Components (List)
- Reserve Portfolio (meet policy liabilities)
- Surplus Portfolio (intended to realize higher returns)
Insurers Constraints
- Legal / Regulatory: Capital Adequacy, Liquidity, Leverage
- Tax / Accounting: Standard Financial Accounting (IFRS, Gaap), Statutory (Regulators), True Economic Accounting (MTM of Assets and Liabilities)
Bank Investment Objectives (List)
Manage liquidity and risk position relative to securities, non-securities, derivatives, liabilities and shareholder capital to produce returns
1) Manage interest rate risk
2) Manage liquidity
3) Produce income
4) Manage credit risk
Insurer Investment Objective (List)
- Manage investment portfolios with a focus on liquidity
- Grow surplus over time (sensitive to any loss of principal or interruption in investment income)
Banks / Insurers Duration Mgmt (Formula)
(i) A = L + E
(ii) ΔA = ΔL + ΔE
(iii) ΔA/A = ΔL/L + ΔE/E
(iv) ΔE/E = ΔA/A(A/E) - AL/L(L/E)
sendo (L/E) = (A/E) - 1
Banks/ Insurers Duration Mgmt (Formula)
Dequity = Dasset(A/E) - Dliability(Δi/Δy)*(L/E)
sendo:
Δi/Δy = variation in effective yields in liabilities (i) and variation in yields (y)
A/E = Leverage of Assets
L/E = Leverage of Liabilities
Duration Management Formula in terms of Correlations (Formula)
(i) σ^2portfolio = w1^2σ1^2 + wσ2 - [2w1w2pσ1σ2]
Leitura: variância do delta equity = alavancagem do ativo * variância do ativo + alavancagem passivo * variância passivo - 2*correl entre ambos
(ii) σ^(delta eqt/eqt) =
(iii) [(A/E)^2* (σ^2ΔA/A)] +
(iv) [(L/E)^2(σ^2ΔL/L)] -
(v) 2(A/E)(L/E) [p correl entre σΔA/A eσ^2ΔL/L]
Conclusions on Duration Management (List)
1) ↑ Leverage = ↑ More Critical to match Duration Assets = Duration Liabilities to not get equity volatility
2) ↑ Positive Correlation between assets and liabilities = ↓ Effects on equity given assets and liabilities changes
Effect of Prepayment Penalties on Equity (Rationale)
↑ Prepayment Penalties = ↑ p (correlation)
Rationale: ↓ i = ↑ Prepayment = ↑ Risk of Refinancing. Penalties help to maintain them for more time.
Effect of catastrophic insurance risks on Equity (Rationale)
Insurance Risk = ↑ΔL/L
Rationale: Higher risk of uncertain liabilities
Items impacting ΔL/L
1) Catastrophic Insurance Risk = ↑ΔL/L
2) Derivatives transparency = ↓ ΔL/L
3) Surrender penalties = ↓ ΔL/L
4) Predictability of underwriting losses: ↓ΔL/L
Items impacting ΔA/A
1) Common Stock Investments = ↑ΔA/A
2) Diversify Fixed Income Investments = ↓ΔA/A
3) High Quality Bonds = ↓ΔA/A
4) Variable Annuities = ↑ΔA/A and ↑L/L and correl between both
