Topic 4: Institutional Asset Owners and Investment Policies Flashcards
Why standard optimisation models (e.g. MVO) cannot be used?
- issues with estimating risk premium, correlations
- lumpy asset classes
- availability of some investments
What is the Corpus
Initial contribution of an endowment
Spending rate vs Liability Discount Rate vs inflation. Which is for Foundation/Pension/Endowment
Foundation: spending
Pension: liability
Endowment: inflation
What are the three basic dimensions for naive allocation
- Absolute allocation size
- Allocation relative to portfolio
- Regular liquidity needs
What is the most appropriate benchmark for evaluating total portfolio performance?
- Broad peer group
- Weighted benchmark of broad market indices
- Market index for each strategy
Total portfolio performance should be assessed based on a weighted benchmark consisting of broad market indices aligned with the asset owner’s strategic allocation targets.
Other responses: A market index for each strategy or a peer group is used to evaluate the performance of the managers in the portfolio.
Which U.S. asset owner is required, for tax purposes, to distribute a minimum percentage of their assets each year?
Foundation
What is the difference between Foundation and Endowment?
Foundation:
- gives grants, while endowments are investment funds
- tend to have finite lives, while endowments are perpetual
- subject to min. spending
- less likely to receive funding from ongoing donations
Six attributes of the Endowment Model
- Aggressive Asset Allocation
- Effective manager selection
- First mover advantage
- Access to network
- Acceptance of liquidity risk
- Sophisticated investment staff and board oversight
What is tail risk?
Risk of sizeable portfolio value loss, resulting in returns that are in the far left end of return distribution
Sheikh and Sun (2012) suggest that the optimal level of liquid fixed-income holdings in a typical endowment portfolio best corresponds to which of the following ranges?
6 to 14%
When is rebalancing beneficial?
- Mean-reverting
- Oscillating
- Trending
- Flat
Rebalancing is beneficial in mean-reverting markets; i.e., it can enhance returns and reduce risks.
Other response: Rebalancing can reduce returns in trending markets
Rank assets from lowest to highest inflation beta:
Equities
T Bills
Treasury Bonds
Commodities
US equities
- Treasury Bonds
- US equities
- T Bills
- TIPS
- Farmland
- Commodities
Three types of pension plans
- defined benefit
- defined contribution
- govt social security plans
Three approaches to managing assets in defined benefit plans. Explain:
1. Asset focused:
2. Asset-liability:
3. Integrated asset-liability:
- Asset focused: Cash considered riskless assets. earns max expected returns
- Asset-liability: SD is low when correlation between asset and liability is high. Less risky when a volatile asset that is positively correlated with change in liability
- Integrated asset-liability: negative correlation with the sponsor’s profitability is preferred
In the asset-liability framework, hedging bucket can be constructed in three ways. Explain:
1. Duration matching
2. Cash flow matching
3. Overlay approach
Duration matches liabilities
Future cash inflows match expected liability cash outflows
Uses financial derivatives which may result in leveraged positions. Overlay method advantage is that you don’t need to give up growth portfolio, i.e. interest rate swap to receive fixed interest rate in exchange for variable
Projected Benefit Obligation
Present value of benefits assumed to be paid to future retirees.
- Corporate bond yields increase, PBO declines
- Yields decrease, PBO increases
% change in liabilities = - modified duration x change in yield
Which of the following statements is true of annuities?
1.cDeferred annuities cost less than immediate annuities.
2. 20-year annuities cost more than 25-year annuities.
3. Fixed annuities cost less than growth annuities.
4. Interest rates and annuity costs are positively correlated.
1 and 3
Deferred annuities cost less than immediate annuities, and fixed annuities cost less than growth annuities. The growth in the annuity payment contributes to the additional cost relative to a fixed annuity.
Payment periods and annuity costs are positively correlated: the longer the payment period, the more costly the annuity.
Interest rates and annuity costs are negatively correlated: the higher the interest rate, the less costly the annuity.
Which of the following are three key investment risks to which retirees are exposed?
Longevity
Market
Inflation
Advantages of pension funds over individual self-directed retirement savings plans:
- Trained staff and external managers
- Economies of scale - enable pension funds to easily meet minimum investment requirements of alternative investments and negotiate preferential terms.
- Pooling of mortality risk - enables pension plan to allocate more to illiquid assets.
- More predictable mortality risk
4 factors affect the value of a pension plan’s liabilities:
1) interest rates
2) inflation
3) retirement cycle
4) mortality rate
When will a pension plan be exposed to surplus risk?
NEGATIVE/POSITIVE correlation between the annual changes in assets and liabilities
If there is a NEGATIVE correlation between the annual changes in assets and liabilities
Which of the following represents accepted principles and practices of good governance of sovereign wealth funds?
A. Santiago Principles
B. Global Investment Performance Standards
C. Linaburg-Maduell Index
D. Fundamental Law of Active Management
Santiago Principles
- Linaburg-Maduell Transparency Index: rating transparency in sovereign wealth funds.
- The Global Investment Performance Standards (GIPS) - this is a set of principles that guide investment firms on how to calculate and present their investment results to clients and prospective clients.
- Fundamental Law of Active Management - this expresses an active portfolio manager’s information ratio: the risk-adjusted value added by the manager as a function of the manager’s skill to forecast returns and the number of markets to which the manager’s skill is applied.
Sterilization of a central bank’s foreign currency market transaction results in the transaction having no effect on which of the following?
A. domestic money supply
B. balance of payment surplus
C. foreign exchange rate
D. foreign money supply
Sterilization refers to a central bank neutralizing the effects of its foreign exchange market interventions on the supply of domestic currency. As a result, the interventions will have no effect on the domestic money supply.
The process involves the central bank selling or buying domestic government bonds in the amount it buys or sells foreign currency on the foreign exchange market (which results in the amount of domestic currency in circulation remaining unchanged).
Currency tends to appreciate in the following conditions:
1. ___ inflation rate that trading partners
2. ___ real interest rates than trading partners
3. capital ___
4. ___ income growth that reduces demand for imports
5. competitive advantage in exports
- lower inflation rate that trading partners
- higher real interest rates than trading partners
- capital inflows
- slower income growth that reduces demand for imports
- competitive advantage in exports
Categories of Wealth in Chhabra’s framework?
Tangible: House, art. etc.
Financial: Bank account
Human: talent
Categories of Risks in Chhabra’s framework
Personal – risk to a person’s basic standard of living (job loss, divorce, disease, etc.)
Market – risk from exposure to financial markets
Aspirational – risk specific to one or a small group of assets with potential for large loss
Which of the following is the expected annual value added to individual investors’ net performance of behavioral coaching by wealth management advisors?
1.5%
What is the Dutch Disease
Dutch disease is an economic term for the negative consequences that can arise from a spike in the value of a nation’s currency.
China - what is the difference between SAFE and CIC?
CIC: Reserve investment Fund
SAFE: Stabilisation fund by central bank
Santiago Principles vs Linaburg Maduell Index
Santiago: governance fo sovereign wealth funds
Lindaburg-Maduell: rating transparency in SWF
Define Mental Accounting
Tendency of investors to compartmentalize their assets (e.g. home, stock portfolio, etc.) into separate categories with their associated risks rather than as a holistic portfolio
