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CFA Level III > Session 14 > Flashcards

Session 14 Flashcards

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1
Q

Common characteristics of institutional investors

A 
1/ Scale (size)
2/ LT investment horizon
3/ Regulatory FM
4/ Governance FM
5/ Principal- agent issues
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2
Q

Scale (size) of institutional investors

A
  • 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
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3
Q

Long term investment horizon of institutional investors

A
  • long inv. horizons + low liquidity needs allow for holdings of alternative investments
  • banks/insurance → perpetual horizon but typically short maturity holdings
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4
Q

Regulatory frameworks of institutional investors

A

➝ legal, regulatory, tax, accounting
– differ by national jurisdiction
Key drivers: investor protection, safety/soundness of financial institutions, integrity of financial markets

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5
Q

The governance framework of institutional investors

A

→ BoD + investment committee establish investment policy (SAA), define risk appetite, set investment strategy, monitor investment performance
- banks/insurance implement investment internally

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6
Q

Principal-agent issues of institutional investors

A
  • 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
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7
Q

Implementation approaches of Investment Policy

A

1/ Norway model
2/ Endowment model
3/ Canada model
4/ Liability- driven investing (LDI) model

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8
Q

Norway Model

A
  • 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
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9
Q

Endowment Model

A
  • 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
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10
Q

Canada Model

A
  • high AI exposure, active mgmt., insourcing
    +/ high value-added potential, development of internal capabilities
    –/ potentially expensive, difficult to manage
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11
Q

Liability- driven investing (LDI) model

A
  • 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
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12
Q

Benefit payments, Contributions, Investment Decision making, Investment Risk, Mortality/Longevity risk of DB

A
  • 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
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13
Q

Benefit payments, Contributions, Investment Decision making, Investment Risk, Mortality/Longevity risk of DC

A
  • 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
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14
Q

Stakeholders of DB

A
  • 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
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15
Q

Stakeholders of DC

A
  • 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
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16
Q

Liabilities of DB

A
  • 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
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17
Q

Liabilities and Investment Horizon of DC

A

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

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18
Q

Liabilities need of DB is driven by

A

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

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19
Q

Funded ratio formula

A

= FV (plan assets)/PV (benefit obligation)

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20
Q

The investment horizon for DB

A
  • 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
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21
Q

How is the DB funded?

A
  • 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
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22
Q

External Constraints of DB and DC

A 
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)
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23
Q

Risk Considerations for DB

A 
1/ Plan Funded Status of DB
2/ Sponsor Financial Strength
3/ Sponsor and pension fund common risk exposures
4/ Plan design
5/ Workforce characteristics
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24
Q

Expand on plan Funded Status of DB

A

→ 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

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25
Q

Expand on Sponsor Financial Strength

A
  • 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
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26
Q

Expand on Sponsor and pension fund common risk exposure

A
  • correlation of sponsor operating results with pension asset returns high → lower risk tolerance
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27
Q

Expand on Plan design

A
  • provision for early retirement
  • provision for lump-sum distributions
  • both reduce the duration of the plan liabilities = lower RT
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28
Q

Expand on Workforce characteristics

A
  • 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
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29
Q

Risk objectives of DB

A

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

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30
Q

Return objectives of DB

A
  • 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)
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31
Q

Investments Objectives of DC

A
  • to grow assets be sufficient to fund for one’s spending needs during retirement
  • outperform policy BM or outperform other DC plans
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32
Q

Investment portfolio - asset allocations of DB and DC

A

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

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33
Q

Sovereign Wealth Funds

A
  • state-owned investment funds (invest in real or financial assets)
34
Q

Five Broad Types of Sovereign Wealth Funds - Liabilities

A

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

35
Q

Stakeholders of Sovereign Wealth Funds

A

➝ current and future citizens
➝ government
➝ external asset managers, SWF mgmt., investment committee

36
Q

Investment Horizon of Sovereign Wealth Funds

A
  • 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
37
Q

Liquidity Needs of Sovereign Wealth Funds

A

➝ 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

38
Q

External constraints of Sovereign Wealth Funds

A
  • Legal & Regulatory – established by national legislation

* Tax & Accounting – tax-free status by legislation

39
Q

Investment Objectives of Sovereign Wealth Funds

A

➝ 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

40
Q

Asset Allocation of Sovereign Wealth Funds

A 
➝ 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
41
Q

University endowments

A
  • 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
42
Q

Foundations

A

grant-making institutions funded by gifts and investment assets

43
Q

4 types of foundations and expand on each one

A

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

44
Q

Stakeholders of Endowments

A
  • current and future students
  • alumni - typically the donors (general or restricted support)
  • current & future faculty/administrators – payouts support operating budgets
45
Q

Investment Horizon of Endowments

A

perpetual (maintain long-term purchasing power)

46
Q

Liabilities of Endowments

A

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%)

47
Q

Spending Policies of Liabilities of Endowments

A

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

48
Q

Other issues in Liabilities of Endowments

A

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

49
Q

Liquidity needs of Endowments

A

– 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
50
Q

Stakeholders of Foundations

A

➝ founding family
➝ donors
➝ grant recipients
➝ broader community

51
Q

Investment Horizon of Endowments

A

– very long-term/perpetual, except for limited life

52
Q

Liabilities of Foundations

A

➝ 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

53
Q

Liquidity Needs of Endowment

A

– relatively low, annual net spending of at least 5%

54
Q

External constraints of Endowment

A

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

55
Q

Investment Objectives of Endowment

A

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

56
Q

Investment Objectives of Private Foundations

A

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

57
Q

Asset Allocation for University endowment

A
  • most large endowments follow the endowment model
  • larger size = larger AI allocation
  • smaller size = larger FI allocation larger US equity allocation (Home bias)
58
Q

Asset Allocation for Private foundations

A

· 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

59
Q

Stakeholders of Banks

A
  • External: shareholders, creditors, customers, credit rating agencies, regulators
  • Internal: employees, mgmt., BoD
60
Q

Balance Sheet Approach of banks

A

Liabilities → Depositors (indiv., corp., gov’t.), derivative counterparties, creditors
Assets → retail commercial borrowers

61
Q

Liabilities of Bank

A
  • 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.)
62
Q

Investment Horizon of Banks

A

– perpetual life

- short to medium term maturity A/L

63
Q

Liquidity needs of Banks

A
  • 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
64
Q

Stakeholders of Insurance/

A

External → shareholders, derivative counterparties, policyholders, creditors, regulators, rating agencies
Internal → employees, mgmt., BoD

65
Q

2 forms of insurance

A

stock companies with shareholder ownership

mutual companies with policyholder ownership

66
Q

Liabilities and Investment Horizon: Insurers/

A
  • 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)
67
Q

Liquidity needs: Insurers - Life and P/C

A
  • 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)
68
Q

Insurer’s investment portfolios segmented into 2 major components

A

1/ Reserve portfolio ➝ meet policy liabilities (highly liquid, low risk)
2/ Surplus portfolio ➝ intended to realize higher returns (may have AI)

69
Q

External constraints of Insurers

A

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

70
Q

Expand on Legal/Regulatory- External constraints of Insurers

A

complex and vary by jurisdiction - regulators focus on

1) capital adequacy
2) liquidity
3) leverage
- attempt to mitigate systemic or contagion risk

71
Q

Expand on Capital adequacy - External constraints of Insurers

A

➝ 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

72
Q

Expand on Tax/Accounting - External constraints of Insurers

A

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

73
Q

Investment Objectives of Bank

A
  • 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
74
Q

Objectives in managing securities portfolio of Bank

A

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

75
Q

Investment Objectives of Insurance Company

A
  • 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
76
Q

Investment Strategy of Insurance Company

A
  • need is to fund deposits, policy claims, derivatives payoff, debtholders
  • underlying investment strategy is mainly LDI
77
Q

R/S between Duration asset and Duration liability

A

· 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

78
Q

To lower DA

A

➝ 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

79
Q

To raise DL

A

➝ issue intermediate/long-term debt
➝ use subordinated capital securities (CoCo bonds)
➝ perpetual preferred ➝ futures, swaps

80
Q

What happens if p=1 to the volatility of E? What happens if p/correlation drops to the volatility of E?

A
  • 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 ↑

CFA Level III (12 decks)

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