investment policy statement of all institutions

35
Lecture 04 Chapter 3 Managing Institutional Investor Portfolios

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investment policy statement of all institutions

Transcript of investment policy statement of all institutions

Page 1: investment policy statement of all institutions

Lecture 04Chapter 3Managing Institutional Investor Portfolios

Page 2: investment policy statement of all institutions

2 Portfolio Management ProcessPLANNING

Capital Market Expectations E(r)/σ

PLANNINGInvestor Objective & Constraint

FEEDBACKPerformance/Monitoring Performance measures Sp

Attribution analysisREBALANCE

PLANNINGStrategic Asset Allocation

Efficient Frontier Based on objective/constraints, max return on risk adjusted basis

EXECUTIONTactical Asset Allocation

Security AnalysisTransaction Costs

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3FOCUS of LECTURE:

1. Pension Funds

2. Foundations & Endowments

3. Insurance Industry

4. Banks & Other Institutional Investors

IPS for institutions is similar to individuals except that IPS must consider liabilities that have been entered into

Asset/Liability Management (ALM) managing investment of assets to control relative asset/liability values

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4 Pension FundsGeneral Definitions Pension Plan

portfolio of assets that supports PROMISE to plan participants

promises MIGHT represent liability of plan sponsor

Plan Sponsor organization (corporation, non profit entity, government) that provides some or all of funds pension plan

Plan Participants receive promise related to retirement

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5 Pension FundsTypes of Pension Plans Defined-benefit (DB) plan agreement that Plan

Sponsor promises specific BENEFIT to Plan Participants based on formula (related to years of service & rate of pay) PROMISE generates future financial obligation or

liability If individual account is maintained for each

individual Plan Participant is defined Cash Balance Plan

Defined-contribution (DC) plan agreement that Plan Sponsors make CONTRIBUTION to Pension Plan. Liability to Plan Sponsor is limited to their contribution Types

Pension PlansProfit Sharing Plans which are tax advantaged

Sponsor directed (profit sharing plan) sponsor selects investments

Participant directed Employee allocated retirement among available investment funds

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6 DB vs DCType Plan

Employer Employee

DB

DC

Pension Benefits are liability for employer

Benefits are determine by criteria such as years of service & salary

Plan Sponsor are responsible for managing plan assets to meet pension obligations

Received periodic payments at retirement based on formula

Subject to early termination risk if employee is terminated prior to retirement

Does NOT bear risk/return consequences of portfolio performance Company promises to

keep contributions current Only financial liability is

making contributions Plan MUST offer

employees sufficient number of investment vehicles for suitable portfolio construction

Owns plan assets & can transfer account to other qualified plans

Must make ALL investment decisions given available investment vehicles

Bears ALL investment risk

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7 Defined-Benefit (DB) PlanPension assets MUST FUND payment of LIABITIES related to pension benefits (ALM)Pension Plan’s investment performance should be judged on absolute basis but also adequacy of its assets with respect to liabilitiesFunding Status relationship between value of

plan’s assets & present value of its liabilitiesPensionSurplus

Market valuePension Assets= Present value

Pension Plan Liabilities-

Fully Funded Pension surplus > 0Underfunded plan Pension surplus < 0QUESTION: How does DEFINITION of Pension Plan Liabilities impact of Pension Surplus?

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8 Defined-Benefit (DB) PlanDefinitions of Pension Plan LiabilitiesAccumulated Benefit Obligation (ABO) Present value of pension benefits (liabilities)

assumes plan is terminated immediately & provides benefits based on their service to date

excludes impact of future salary increasesProjected Benefit Obligation (PBO) Present value of pension benefits (liabilities)

assumes employee will continue to work & projects future compensation increases

Total Future Liability used for return objective Present value of pension benefits (liabilities) that

includes not only future compensation increases but also includes Changes in benefits associated with inflation Changes in workforce

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9 DB – Risk ObjectivesRisk Objective willingness & ability to bear riskFactors impacting Risk Objective Plan Surplus (cushion) ability to tolerate risk Plan Deficit willingness to tolerate risk but ability to

tolerate risk Sponsor’s financial status

debt/total assets ability to tolerate risk Current & expected profitability ability to tolerate risk

correlation of sponsor operating results (net income) with pension asset returns ability to tolerate risk

Plan features if NO provision for early retirement ability to tolerate

risk if NO provision for lump-sum distribution ability to

tolerate risk Work force characteristics

younger age of workforce ability to tolerate risk ratio of active lives to retired lives ability to tolerate

riskThis is task performed by actuary support info in f/s

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10 DB – Risk ObjectivesConsider DB plan / Plan Sponsor with following characteristics Plan assets are 108% of present value of pension

obligations (liabilities) ability to tolerate risk Balance sheet of Plan Sponsor is very strong:

debt/total assets ability to tolerate risk Earnings of Plan sponsor are very strong despite

operating in cyclical industry: correlation of sponsor operating results with pension asset returns ability to tolerate risk

Age of workforce is very low ability to tolerate risk

QUESTION: What is ability of DB plan to tolerate risk?

ANSWER: Ability to tolerate risk is above average

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11 DB – Return ObjectivesPossible Return Objectives for DB Return objective is to achieve returns that funds its pension liabilities (on inflation adjusted-basis) Return pension assets ≥ discount rate used to calculate present value of liabilities (PBO) Return Objectives based on contributions

Stretch Target make future pensions contributions = 0

Realistic Objective minimize amount of future pension contributions (expressed on undiscounted or discounted basis)

Return Objectives based on pension income Minimize pension expense (return on pension

assets reduces pension expenses) reflected on income statement

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12 DB – ConstraintsFactors impacting on DB ConstraintsLiquidity Requirement (benefit payments – pension contributions)

number of retired lives liquidity requirement plan sponsor’s contribution relative to benefit disbursements

liquidity requirement Plan features such as early retirement liquidity requirement

Time Horizon Plan is going concern (on going) vs plan termination is expected

(shorter) Younger workforce & larger proportion of active lives time

horizonTax DB Plan are tax exempt thus decisions can be made without

considering taxLegal & Regulatory

DB Plan must adhere to laws & regulationsUnique Circumstances

Laws & regulations may required plan sponsors to exercise due diligence

Plan sponsors may have imposed social responsibility constraints on types of securities that can be held

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13 Defined-Contribution (DC) PlanTypes of DC Plans Participant directed Plan Sponsor directed

Principal Investment Issues Diversification Plan sponsor MUST offer menu

investment vehicles to construct suitable portfolios At least three (3) investment choices Provision to move between investment choices

Company Stock investment in plan sponsor’s stock should be limited

DC Investment policy enable number of different individual investor objectives & constraints

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14 Hybrid & Other PlansHybrid Plans combine features of DB & DC plansDB plans Cash balance plan provides personalized

statement includes Annual contribution credit % of pay based on

age Earnings credit % increase tied to LT interest

rateDC Plans Employee stock ownership plans (ESOP)

encourage employees to become stockholder of their employers which may be either before or after tax plans

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15 Foundations vs EndowmentsFoundation ford foundation Grant-making institutions (not legal obligations) Funded by gifts & investment assets Investment income is dominant source of revenue Private foundations funded by single donor LEGISLATED minimum level spending (to qualify

as non taxable) % assets (say 5%) or % investment income (say 85%)

Endowment Long term funds owned by operating nonprofit

institutions like universities & hospitals that are intended to provide permanent funding (but not legal obligations)

Built up over time by many individual gifts NOT subject to specific legally required spending

level Each gift may have specific conditions regarding

intended use

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16 Foundations - ObjectivesRisk Objective Foundation has NOT entered into contractual

agreements to provide grants, they have NO liabilities above average risk tolerance

Return Objective Reliability flow of funds is extremely important Short-lived foundation varying return objectives Long-lived foundation (perpetuity)

Preserve real value investment assets while Allow spending at appropriate rate = minimum

payout + management fee + inflation

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17 Foundation – Constraints

Time Horizon Finite life Spend Down Rate determines time period, as it

approaches end of life, usually becomes more conservative Infinite life perpetuity

Liquidity Requirement Distribution is determined by foundation’s Spending Rate Spending rate tend to be conservative & utilize Smoothing

Rules

Tax Foundations subject to NO or NOMINAL (1-2%) tax

Legal & Regulatory Foundation must adhere to laws & regulations (minimum spending) Prudent Investor Rule ALL investments evaluated from portfolio

perspectiveUnique Circumstances Gift consisting of single stock with condition that it CANNOT be

sold

Factors impacting on Foundation Constraints

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18 Endowments - GeneralEndowments Legal entity with portfolio assets Goal of providing permanent funding for activity Gifts may be

Restricted ONLY used for specific purposes Unrestricted used for general purposes

Prior to 1970, Level Spending was based on interest & dividend income portfolio more heavily weighted towards high-yielding fixed income securities

Today, Level Spending based on concept “total return” Spending Rate applied to market value assets

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19 Endowments – Spending RatesDefinitions:S = spending rate % of assetsMKt = market value assets @ end of period tR = smoothing rate (0.6 – 0.8)i = inflation rateSimple Spending Rule$ Spendingt S= MKt-1✖

Problem with simple spending rule is level dollar amount of spending will vary function of market value Rolling 3-year average spending Rule

$ Spendingt S= MKt-1 + MKt-2 + MKt-3

3✖

Use average of market values smooth out Level of Spending Geometric smoothing Rule

$ Spendingt = R ✖ Spendingt-1 ✖ (1+it-1)

+ (1-R) ✖ S ✖ (MKt-1)

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20 Endowments - ObjectivesRisk Objective IPS? Because they are perpetual, they can accept short-

term portfolio volatility IF portfolios have very low volatility, they will

only provide low expected rates of return IF endowment has high return objective to satisfy

relatively high spending needs it implies it needs high willingness to accept risk

Return Objective IPS? General objective is to provide significant, stable &

sustainable stream of spending distributions tend to have high return objectives

Also should maintain long-term purchasing power after inflation

To maintain purchasing power, endowment must keep its long-term expected real return > long-term average spending rate

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21 Endowment – Constraints

Time Horizon Infinite life perpetuity or extremely long

Liquidity Requirement Limited liquidity required other than cash for spending

distributions Appropriate to include illiquid, non marketable securities as assets

Tax In general Endowments not subject to tax

Legal & Regulatory Few laws & regulations Board exercise ordinary business care & prudence Spending must comply with used restrictions imposed by donor

Unique Circumstances Endowment funds are diverse with different unique requirements

Factors impacting on Endowment Constraints

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22 Life Insurance - GeneralInsurance companies Viewed absorbers of personal & business risk Because of contractual obligations to policy

holders, investment practices have been characterized conservative

Types of Insurance companies Life uncertainty with timing of payout Non life uncertainty with timing & amount of

payout Health Property & liability

By ownership Stock companies (issued common equity) Mutuals (owned by policyholders) most are in

process of demutualizing & converting to stock companies

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23 Life Insurance - ObjectivesRisk ObjectiveTo absorb loss of due to write down of assets, companies are required to maintain Asset Valuation Reserve (minimum amount of equity) based on quality tests for each class of invested assetsMove towards risk-based capital (RBC) to ensure that company has adequate surplus (equity) which considers both asset & liability risk exposures Valuation Concerns in periods of increasing interest

rates, mismatch in duration between assets & liabilities can result in erosion of surplus portfolio & reduces risk tolerance

Cash flow volatility loss of income or delay in collecting income & reinvesting cash flow reduces risk tolerance

Reinvestment risk risk of reinvesting coupon at rate < original market rate of interest reduces risk tolerance

Credit risk associated with investing in corporate bonds generates higher return but at cost of greater probability of default

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24 Life Insurance - ObjectivesReturn Objective Assets selected match duration liabilities Minimum return statutory rate determined by

actuaries Enhanced margin minimum return & net interest

spread which is competitive return on assets that funds well-defined liabilities

Surplus return return on surplus portfolio which permits insurance company to offer competitive premiums

Segmentation insurance company establishes return objectives for each major line of business

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25 Life Insurance – Constraints

Time Horizon In general 20 to 40 years Because of segmentation, each product line may have different

time horizons

Liquidity Requirement Disintermediation during periods of high interest rates,

policy holders may surrender their policies creating cash outflow Asset Marketability risk portion of assets may be invested in

less liquid securities

Tax Income that belongs to policyholder not subject to tax in hands of

company Income due to surplus portfolio is taxable in hands of company

Factors impacting on Life Insurance Constraints

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26 Life Insurance – Constraints

Legal & Regulatory (heavily regulated) Eligible investments regulations dictate eligible investments &

asset classes Prudent Investor Rule Each investment must be analyzed from

portfolio perspective rather than on stand alone basis Valuation method (assets & liabilities) regulations specify

valuation methods Risk based capital requirements

Unique Circumstances Insurance company’s size & amount of surplus portfolio

Factors impacting on Life Insurance Constraints

Page 27: investment policy statement of all institutions

27 Non Life Insurance - GeneralGeneral Characteristics of Non Life Insurance Liability duration tend to be shorter but claim

processing & payment periods are longer (long tail) relative to life insurance company

Some non-life insurance are expose to inflation risk (insured for replacement cost)

Uncertainty in both timing & amount of liability payment

Non-life insurance have underwriting (profitability) cycle averaging 3-5 years. Beginning of cycle, underwriting losses are

negligible but End of cycle, underwriting losses are

progressively worse

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28 Non Life Insurance - ObjectivesRisk ObjectiveDue to relatively high uncertainty, non life insurance companies tend to have limited risk toleranceInflation risk may also be issue Cashflow characteristics may be erratic &

unpredictable especially when taking underwriting cycle into consideration

Common stock-to-surplus ratio set between 50% to 75% (ie < 100% exposure to equity)

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29 Non Life Insurance - ObjectivesReturn Objective Competitive pricing policy high levels of returns

on investments can be used to reduce premiums to make company more competitive

Profitability high levels of returns on investments can be used to smooth earnings volatility of underwriting cycle

Growth of Surplus Asset supporting liability tend to be fixed income

(which are duration matched) Surplus portfolio tend to be higher return

securities which are intended to grow surplus After tax returns taxable entity Total return focus on total return (rather than

investment income)

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30 Non Life Insurance – Constraints

Time Horizon Shorter than life insurance

Liquidity Requirement Relatively high Increases during end of underwriting cycle

Tax Subject to tax

Legal & Regulatory Fewer laws & regulations than life insurance Risk based capital requirements

Unique Circumstances Current financial status of company

Factors impacting on Non Life Insurance Constraints

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31 Bank - GeneralAsset Liability Management (ALM) Process

Management ofAssets & Liabilities

Quantity Duration

Credit quality

Interest revenue expense

Net interest margin

Interest spread

Mk Value Assets

Liabilities

Leveraged adjusted duration

gap

FinancialPerforman

ce

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32 Bank - GeneralAsset Liability Management (ALM) ProcessNet Interest margin

Interest Spread

Leverage-adjusted duration Gap (LADG) DA DL k = L/A (L = market value liabilities, A = market value

assets)

If LADG = 0 interest rates change will NOT impact market value equity

Value at Risk (VaR)

Net Interest margin

=Interest income – Interest

expenseAverage earning assets

Interest Spread = Yield on assets - Yield on liabilities

Leverage adjusted

Duration gap= DurationAssets - k ✖

DurationLiabilities

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33 Bank - ObjectivesRisk ObjectiveBank’s risk objectives are dominated by funding liabilities Focus is risk relative to liabilities rather than

absolute risk In general they have below average risk

tolerance

Return ObjectivePositive interest spread earn positive interest

spread (difference between bank’s cost of funds & interest earned on loans & other investments)

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34 Bank – Constraints

Time Horizon Determined by average maturity of liabilities which tends to be

short term Average age of assets tend to be short to intermediate term (<10

years)

Liquidity Requirement Assets tend to be very liquid Driven by deposit withdrawals

Tax Subject to tax

Legal & Regulatory (highly regulated) Risk based capital requirements (Basel II & Basel III)

Unique Circumstances Lack of diversification due concentration of assets

Factors impacting on Bank Constraints

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35 Appendix