Session 14 Flashcards
Common characteristics of institutional investors
1/ Scale (size) 2/ LT investment horizon 3/ Regulatory FM 4/ Governance FM 5/ Principal- agent issues
Scale (size) of institutional investors
- small < $25M → may be unable to access certain investments that require a minimum investment
- more likely to rely on external managers and investment consultants
- large → scale benefits → access to investments can attract internal asset managers
- very large > $10B → diseconomies of scale
- unable to access niche investments
- positions would be too small (VC/PE, sm. cap. growth)
- typically pushed into private assets, infrastructure assets
Long term investment horizon of institutional investors
- long inv. horizons + low liquidity needs allow for holdings of alternative investments
- banks/insurance → perpetual horizon but typically short maturity holdings
Regulatory frameworks of institutional investors
➝ legal, regulatory, tax, accounting
– differ by national jurisdiction
Key drivers: investor protection, safety/soundness of financial institutions, integrity of financial markets
The governance framework of institutional investors
→ BoD + investment committee establish investment policy (SAA), define risk appetite, set investment strategy, monitor investment performance
- banks/insurance implement investment internally
Principal-agent issues of institutional investors
- agents may be internal or external
e. g. → high base fee interests regardless of performance - managed through highly developed performance governance models, high levels of accountability
Implementation approaches of Investment Policy
1/ Norway model
2/ Endowment model
3/ Canada model
4/ Liability- driven investing (LDI) model
Norway Model
- traditional style, 60/40 equity/FI allocation, very few AI, largely passive, tight error tracking limits
+/ low cost, transparent, suitable for large scale, easy to understand
–/ limited value-added potential
Endowment Model
- high AI exposure, active mgmt., outsourcing
(externally managed assets) - suitable for: long-term inv. horizon, low liquidity needs, skill in sourcing AI
+/ high value-added potential
–/ expensive, difficult to implement for very large funds/small funds
Canada Model
- high AI exposure, active mgmt., insourcing
+/ high value-added potential, development of internal capabilities
–/ potentially expensive, difficult to manage
Liability- driven investing (LDI) model
- focus on hedging liabilities and interest rate risk by using duration-matched FI exposure
- may also include a growth component
+/ explicit recognition of liabilities as part of the investment process
–/ certain risks (longevity, inflation) may not be hedged
Benefit payments, Contributions, Investment Decision making, Investment Risk, Mortality/Longevity risk of DB
- benefit payments: defined by the contract
- contributions: mainly employer, sometimes employee
- investment decision making: pension fund determines how much to save and what to invest in
- mortality/longevity risk: employer/sponsor
- mortality risk is pooled
- employee has no longevity risk
Benefit payments, Contributions, Investment Decision making, Investment Risk, Mortality/Longevity risk of DC
- benefit payments: depends on how well the investments did
- contributions: - primarily employee (may involve employer also)
- investment decision making: - employee determines how much to save and what to invest in
- investment risk - employer bears the risk
- mortality/longevity risk: employee
Stakeholders of DB
- employer (plan sponsor) - benefits are the company’s liabilities
- employees and retirees (plan’s beneficiaries)
- CIO and investment staff - must make decisions for the plan’s beneficiaries
- governments
- unions
- shareholders –> shortfalls are liabilities, contributions reduce net income
Stakeholders of DC
- plan beneficiaries
- the employer who still has the fiduciary responsibility (offer suitable investments, employer contributions, education)
- the board, who select the default investment option
- gov’t
Liabilities of DB
- PV of the future obligation/payments for the pool (depends on the age of service, salary, life expectancy)
- also requires a discount rate: typically, a market-rate
e. g./ gov’t. yields, IG corporate yields, swap rates (LIBOR) - most pensions use a liability-driven investing approach
- in cases where increases in expected returns (taking on higher risk) will result in a higher discount being used
- main objective is to have sufficient assets to cover benefit payments
- shortfall = BS liability (encourages more risk-taking)
- surplus = BS asset
Liabilities and Investment Horizon of DC
Liability → equal to the contribution (for the sponsor/employer)
Investment horizon: each beneficiary will be at a different life stage
∴ given different risk tolerance & time horizon
- provide life-cycle options or target-date options
Liabilities need of DB is driven by
1/ proportion of active to retired - more mature, higher liquidity needs
2/ participant switching/withdrawals
- if allowed, higher liquidity needs
3/ age of the workplace - if older, sooner liquidity needs/higher liquidity needs
4/ plan funded status - surplus, means fewer contributions will be made, thus higher liquidity needs
Funded ratio formula
= FV (plan assets)/PV (benefit obligation)
The investment horizon for DB
- proportion of the plan assets and liabilities to the BS
- if small, higher risk tolerance, longer IH
- correlation between the company’s business and the plan assets
- if low, higher RT, longer IH
- avg age of the workforce
- if young, higher RT, longer IH
- volatility of contributions tolerable → longer IH
- active/retired mix → lower retired portion → longer IH
How is the DB funded?
- funded from two sources - employer/employee contributions and return on plan assets
- employer contributions vary depending on funded status
- may want to minimize contributions, minimize the volatility of the surplus
External Constraints of DB and DC
Legal & Regulatory/ varies by country - similar themes: ➝ reporting & transparency ➝ funding requirements ➝ discount rates Tax & Accounting/ restrictions on plan design, governance, and investment activities in order to qualify for favourable tax treatment DB/ – typically tax exempt DC/ – typically tax-deferred (contributions are pre-tax)
Risk Considerations for DB
1/ Plan Funded Status of DB 2/ Sponsor Financial Strength 3/ Sponsor and pension fund common risk exposures 4/ Plan design 5/ Workforce characteristics
Expand on plan Funded Status of DB
→ higher funded status → greater risk tolerance
if (fully-funded)
•LDI, duration-mgmt., cash-flow matching
if (under-funded)
• grow assets at a higher rate than liabilities - involves more investment risk
• invest in more defensive assets to reduce
funded status variability – plan sponsor is willing to make higher contributions over time
Expand on Sponsor Financial Strength
- if the plan assets/liabilities is a large % of the sponsor’s BS –> lower RT
- lower financial strength → higher future contribution risk
Indicators of lower financial strength:
• high debt ratios
• low current & expected profitability
Expand on Sponsor and pension fund common risk exposure
- correlation of sponsor operating results with pension asset returns high → lower risk tolerance
Expand on Plan design
- provision for early retirement
- provision for lump-sum distributions
- both reduce the duration of the plan liabilities = lower RT
Expand on Workforce characteristics
- older workforce, higher liquidity rqment, and lower RT
- higher ratio of retired lives, higher liquidity rqment, and lower RT
- lower workforce turnover (loyal) –> higher vesting rate –> higher liability (PBO)
- retired workers → longevity risk for sponsor → increased life expectancy = higher PBO
Risk objectives of DB
maybe stated in terms of pension surplus volatility or in terms of the shortfall
A/ relative to liabilities
• funded status of 100% w.r.t. PBO
• funded status above some level to avoid reporting a pension liability
• funded status above some regulatory threshold
B/ relative to contributions
• minimizes year to year volatility of future contribution payments
• minimizes the probability of having to make future contributions
may also state absolute risk objectives
Return objectives of DB
- achieve returns that adequately fund its pension obligation on an inflation-adjusted basis
- achieve a long-term rate of return on plan assets that exceeds the assumed discount rate
∴ return requirement = discount rate used to calculate PVliabilities - return objective may be related to
a) future pension contributions – make future contributions = 0
b) pension income ➝ maintain or increase pension income (a well-funded plan can generate negative expense)
Investments Objectives of DC
- to grow assets be sufficient to fund for one’s spending needs during retirement
- outperform policy BM or outperform other DC plans
Investment portfolio - asset allocations of DB and DC
1/ Equities
- hedge against inflation, growth role
- allocation to equities has been decreasing over time
2/ Fixed Income
- defensive role, hedge interest rate risk
- holdings may have a regulatory minimum
- reduces the volatility of the funded ratio
3/ Alternative Investments
- can act as an inflation hedge
- small or negative correlation with other assets classes
Sovereign Wealth Funds
- state-owned investment funds (invest in real or financial assets)
Five Broad Types of Sovereign Wealth Funds - Liabilities
1/ Budget stabilization funds – insulate the budget and economy from commodity price volatility and external shocks (capital preservation)
2/ Reserve Funds – reduce the negative carry costs of holding reserves or earn a higher return on ample reserves
3/ Savings Funds – to share wealth across generations by transforming non-renewable assets into diversified financial assets (purchasing power)
4/ Development Funds – allocate resources to socio-economic projects, typically infrastructure (achieve a real rate of return in excess of real domestic GDP or productivity growth)
5/ Pension Reserve Funds – meet future outflows (shortfalls) w.r.t. pension liabilities
Stakeholders of Sovereign Wealth Funds
➝ current and future citizens
➝ government
➝ external asset managers, SWF mgmt., investment committee
Investment Horizon of Sovereign Wealth Funds
- in general, do not have clearly defined liabilities
➝ Budget stabilization ➝ uncertain liabilities, relatively short IH - avoid assets that are highly correlated with the main source of gov’t. revenue
- mainly invest in gov’t. bonds
➝ Development - uncertain liabilities, medium to long-term IH
➝ Savings ➝ long-term liabilities and IH - risky and illiquid assets, but avoid assets highly correlated with the non-renewable resource it is diversifying from
➝ Reserve ➝ liabilities are the CB, monetary stabilization bonds, long IH
➝ Pension reserve ➝ liability is future pension-related obligations, long-term - accumulation phase/decumulation phase IH
- equity, AI ➝ property, infrastructure, PE
Liquidity Needs of Sovereign Wealth Funds
➝ Budget stabilization
– high level of liquidity
- assets that have a low risk of loss over short periods
(cash, liquid IG, fixed income)
➝ Development
- low liquidity needs
➝ Savings
low liquidity needs
➝ Reserve
- lower than stabilization, higher than savings
➝ Pension reserve
– accumulation phase → low liquidity needs
- decumulation phase → high liquidity needs
External constraints of Sovereign Wealth Funds
- Legal & Regulatory – established by national legislation
* Tax & Accounting – tax-free status by legislation
Investment Objectives of Sovereign Wealth Funds
➝ Budget stabilization
- capital preservation
- returns in excess of inflation with a low probability of a negative return in any given year
➝ Development
– achieve a real rate of return in excess of real GDP or productivity growth
➝ Savings
- maintain the purchasing power of the assets in perpetuity while achieving investment returns sufficient to sustain the spending necessary to support ongoing gov’t. activities
➝ Reserve
– achieve a rate of return above the return the gov’t. must pay on its monetary stabilization bonds
➝ Pension reserve
– earn sufficient returns to maximize the likelihood
of being able to meet future unfunded pension, social security, and/or health care liabilities of plan participants as they arise
Asset Allocation of Sovereign Wealth Funds
➝ Budget stabilization - fixed income and cash ➝ Savings – growth assets (equities, AI) - private debt, HF/PE ➝ Reserve – equity, FI, AI ➝ Pension reserve – large equity, ~ 10 – 15% AI - infrastructure, PE, private debt, HF
University endowments
- long-term investment portfolios of universities
- not subject to a specific legally required spending level
- typically the principal amount of any donation must be preserved in perpetuity
Foundations
grant-making institutions funded by gifts and investment assets
4 types of foundations and expand on each one
1/ Community foundations - make social/educational grants for the benefit of the local community
2/ Operating foundations – operate a not-for-profit business for charitable purposes
3/ Corporate foundations – established by businesses, funded from profits
4/ Private grant-making foundations – established by individual donors/families to support specific types of charities
Stakeholders of Endowments
- current and future students
- alumni - typically the donors (general or restricted support)
- current & future faculty/administrators – payouts support operating budgets
Investment Horizon of Endowments
perpetual (maintain long-term purchasing power)
Liabilities of Endowments
future stream of payouts to the university based on a spending policy
- since the aim is to maintain purchasing power, target real return ≥ spending rate (5% - 5.5%)
Spending Policies of Liabilities of Endowments
1/ Constant growth rate – Fixed income × (1 + infl.)
- typically floor at 4%, cap at 6% of assets
- uses higher education inflation
2/ Market Value Rule - %’age of moving average (3-5 yrs.) of asset value
- tends to be procyclical
3/ Hybrid Rule/ Yale Spending Rule – weighted average of 1 & 2
𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠𝐭”𝟏 = 𝐰[𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠𝐭 × (𝟏 + 𝐢𝐧𝐟𝐥. )] + (𝟏 − 𝐰)(𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 × 𝐀𝐔𝐌)
w = 0 → Market value rule
w = 1 → Constant growth rate
Other issues in Liabilities of Endowments
1/ gifts and donations – offset spending rate
2/ %’age of operating budget supported → lower → higher risk tolerance
3/ ability to issue debt – creates a defined liability, but also allows for more illiquid investments
Liquidity needs of Endowments
– annual net spending → 2% to 4% after gifts and donations
- low liquidity needs, high-risk tolerance, perpetual IH
- allows for significant allocation to illiquid investment classes
Stakeholders of Foundations
➝ founding family
➝ donors
➝ grant recipients
➝ broader community
Investment Horizon of Endowments
– very long-term/perpetual, except for limited life
Liabilities of Foundations
➝ U.S., legal requirement to spend 5% of AUM + investment fees or face tax penalty
➝ must also spend any donation in the yr. received (flow-through)
- maybe able to issue debt
→ creates a defined liability
→increases risk tolerance
- foundations rely on investment returns to support operating budgets
∴ less illiquid investments vs. endowments
Liquidity Needs of Endowment
– relatively low, annual net spending of at least 5%
External constraints of Endowment
Legal & Regulatory – typically
1) invest on a total return basis
2) exercise a duty of care when making investment decisions
Tax & Accounting
- gifts/donations usually tax-deductible for donor
investment income tax-exempt
- payouts are tax-exempt if the receiving institution
is exempt from tax
Investment Objectives of Endowment
primary: - maintain the purchasing power of assets into perpetuity
- generate investment returns sufficient to sustain the
level of spending necessary to support the university budget
- the total real rate of return of 5% with expected volatility of 10-15% over the long-term (inflation = higher education inflation)
secondary: outperform a long-term policy benchmark tertiary: outperform a set of pre-defined peers
Investment Objectives of Private Foundations
primary: generate a total real return of 5% (inflation = CPI) plus investment expense with volatility 10-15% over a 3-5 yr. period
real return + inv. expense + CPI = nominal return
secondary: outperform the policy benchmark within some specified tracking error
Asset Allocation for University endowment
- most large endowments follow the endowment model
- larger size = larger AI allocation
- smaller size = larger FI allocation larger US equity allocation (Home bias)
Asset Allocation for Private foundations
· foundations support an entire budget, universities have other financing sources
· foundations are mandated to payout 5% of AUM to remain tax-exempt
smaller size
→ lower AI allocation
→ higher vs. equity allocation
largest → very low FI allocation
Stakeholders of Banks
- External: shareholders, creditors, customers, credit rating agencies, regulators
- Internal: employees, mgmt., BoD
Balance Sheet Approach of banks
Liabilities → Depositors (indiv., corp., gov’t.), derivative counterparties, creditors
Assets → retail commercial borrowers
Liabilities of Bank
- originate assets (loans), liabilities/deposits, derivatives, FI securities in the normal course of business
largest asset → loans (≥ 50%), then debt securities (≥ 25%)
largest liability → deposits (≥ 50% of T.L.) - time deposits (term deposits) e.g. CDs – specified duration
- demand deposits - assumed short duration
agencies, regulators
+ wholesale funding, long-term debt (10-15% of T.A.), securities payable and repos. (10-20% of T.A.)
Investment Horizon of Banks
– perpetual life
- short to medium term maturity A/L
Liquidity needs of Banks
- short duration deposits, the potential need for increased liquidity in adverse market conditions → banks must maintain mandated liquidity coverage ratios (LCRs) and net stable funding ratios (NSFRs)
- commercial banks → higher cost of funds, lower liquidity
- retail banks → lower cost of funds, better liquidity
Stakeholders of Insurance/
External → shareholders, derivative counterparties, policyholders, creditors, regulators, rating agencies
Internal → employees, mgmt., BoD
2 forms of insurance
stock companies with shareholder ownership
mutual companies with policyholder ownership
Liabilities and Investment Horizon: Insurers/
- business line determines the nature and structure of liabilities
- liabilities are identified with their predictability
Life/ long-term liabilities, high predictability using actuarial analysis on large portfolios, one-time payout, subject to mortality risk
Investment horizon ➝ long-term, 20-40 yrs. (perpetual life however)
Annuities/ ongoing payouts with shorter duration, subject to longevity risk
Property/Casualty: shorter duration liability stream, higher uncertainty
Investment horizon ➝ shorter than life (perpetual life however)
Liquidity needs: Insurers - Life and P/C
- vary based on a line of business
Life: ➝ disintermediation: when rates rise, liquidity requirements arise
P/C: ➝ ample liquidity due to uncertain value & timing of outflows - high proportions of cash & short-term FI securities
- marketable gov’t. bonds of various maturities (laddered)
Insurer’s investment portfolios segmented into 2 major components
1/ Reserve portfolio ➝ meet policy liabilities (highly liquid, low risk)
2/ Surplus portfolio ➝ intended to realize higher returns (may have AI)
External constraints of Insurers
Legal/Regulatory
Capital adequacy ➝ lowering the risk of assets through regulation
- require diversification, specific levels of asset quality, maintaining specified levels of liquidity
- requirements on liabilities ➝ funding sources diversified over time and among different groups
- limit size and concentration of potential policy claims
Expand on Legal/Regulatory- External constraints of Insurers
complex and vary by jurisdiction - regulators focus on
1) capital adequacy
2) liquidity
3) leverage
- attempt to mitigate systemic or contagion risk
Expand on Capital adequacy - External constraints of Insurers
➝ lowering the risk of assets through regulation
- require diversification, specific levels of asset
quality, maintaining specified levels of liquidity
- requirements on liabilities ➝ funding sources diversified over time and among different groups
- limit size and concentration of potential policy claims
Expand on Tax/Accounting - External constraints of Insurers
1) standard financial accounting - IFRS, GAAP
2) statutory accounting - imposed by regulators
- subtraction of intangible assets, acceleration of certain expenses, recognition of additional reserves
- results in lower earnings, lower equity capital
3) true economic accounting - mark-to-market all A/L - results in most volatile earnings
- Banks, Insurance companies are taxable
Investment Objectives of Bank
- primary: manage bank’s liquidity and risk position relative to non-securities assets, derivative positions, liabilities & sh. capitalization
- asset/liability management committee ➝ sets the IPS, has the ability to mandate adjustments on the A or L side of the BS
Objectives in managing securities portfolio of Bank
1/ manage overall interest rate risk - securities are an adjustment
2/ manage liquidity mechanism for interest rate risk
3/ produce income
4/ manage credit risk
- below average risk tolerance w.r.t. securities portfolio
Investment Objectives of Insurance Company
- manage investment portfolios with a focus on liquidity
- grow surplus over time (sensitive to any loss of principal or any significant interruption of investment income)
- mismatches in DA & DL may erode surpluses with
interest rate volatility
Investment Strategy of Insurance Company
- need is to fund deposits, policy claims, derivatives payoff, debtholders
- underlying investment strategy is mainly LDI
R/S between Duration asset and Duration liability
· moderate differences between DA & DL can imply durations for equity that can be sizable in either a pos. or neg. direction (regulators do not want large DA/DL mismatches)
- the higher the leverage, the more critical it is to have DA = DL
To lower DA
➝ hold cash, deposits at CB, foreign reserves, or other zero duration assets
➝ make business loans with floating rates
➝ credit card balances, real estate loans - adjustable rates
To raise DL
➝ issue intermediate/long-term debt
➝ use subordinated capital securities (CoCo bonds)
➝ perpetual preferred ➝ futures, swaps
What happens if p=1 to the volatility of E? What happens if p/correlation drops to the volatility of E?
- if ρ = 1, 𝛔∆𝐄/ 𝐄 shrinks to minimal amounts, even for high leverage
- as correlations between assets and liabilities drop, as leverage increase, so does 𝛔^2∆𝐄 ↑
