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CFA L3 Matheus > Section 5 - R24 - Portfolio Mgmt for Institutional Investors (Pension Funds, Endowment, Banks) > Flashcards

Section 5 - R24 - Portfolio Mgmt for Institutional Investors (Pension Funds, Endowment, Banks) Flashcards

1
Q

Institutional Investors Common Characteristics (List)

A
  1. Scale (small, large, very large)
  2. Long Term Horizon (long, but for banks short maturity holdings) and Low Liquidity Needs
  3. Different Regulatory Frameworks (legal, regulatory, tax, accounting)
  4. Governance Frameworks (BoD, Investment Committee)
  5. Principal-Agent Issues (interests may be not aligned)
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2
Q

Investment / Implementation Approaches (List)

A
  1. Norway Model
  2. Endowment Model
  3. Canada Model
  4. Liability Driven (LDI) Model
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3
Q

Norway Model Inv. Approach (Describe)

A

Traditional. 60/40 Public Equities + Fixed Income. Mostly passive. Tight Tracking Errors.

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4
Q

Endowment Model Inv. Approach (Description and Suitability)

A

Yale. High level of Alternative Investments. OUTsourcing.
Suitability: Long Term, Low Liquidity, Skill in Sourcing AI
Pros: High Value-Added Potential
Cons: Expensive

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5
Q

Canada Model Inv. Approach (Description and Suitability)

A

Active Management. High level of Alternative Investments. Insourcing.
Suitability: Long Term, Low Liquidity
Pros: High Value-Added Potential
Cons: Expensive

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6
Q

Liability Driven Inv. Approach (Description and Suitability)

A

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.

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7
Q

Compare Items between DC and DB Pension Funds (List)

A

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)

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8
Q

Pension Fund Stakeholders: Defined Benefit (List)

A
  1. Employer (Plan Sponsor: PETROS)
  2. Employees and Retirees (Beneficiaries)
  3. CIO and Investment Staff (take decisions)
  4. Government
  5. Unions
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9
Q

Pension Fund Stakeholders: Defined Benefit (List)

A
  1. Plan Beneficiaries
  2. Employer (still has fiduciary responsibility as it offers options)
  3. The Board (select default option)
  4. Government
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10
Q

DB Liabilities, Assumptions, Objective and Horizon (Description)

A

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

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11
Q

DC Liabilities, Horizon, Liquidity Drivers (Description)

A

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

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12
Q

External Constraints on Pension Funds (List)

A
  1. Legal / Regulatory (Reporting, Transparency, Funding Requirements, Discount Rates)
  2. Tax and Accounting (Defined Benefit, Defined Contribution)
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13
Q

DB (Petros) Risk Considerations (List and Describe)

A
  1. Plan Funded Status: (Ativo - Passivo) = ↓ Funded Status = ↑ Risk Tolerance is necessary
  2. Sponsor Financial Strength: ↓ Financial Strength (Debt, Profitability) = ↑ Risk to Future Contributions
  3. Sponsor and Pension Fund Correlation = ↑ Correlation = ↓ Risk Tolerance is necessary
  4. Plan Design: Provisions (early retirements and lump sum distributions)
  5. Workforce Characteristics: older, ratio of retirement
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14
Q

Risk Objectives for Pension Funds (Describe)

A

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

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15
Q

Return Objectives for Pension Funds (Describe)

A

a. In terms of Future Pension Contributions: zerar futura necessidade de contribuição
b. Pension Income: aumentar PMT de aposentadoria

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16
Q

Differentiate DC and DB Return Objectives (Describe)

A

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.

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17
Q

Pension Fund Asset Classes Possibilities (List)

A

EFA

  1. Equities: Growth role, Inflation hedge
  2. Fixed Income: Defensive role, hedge interest rate risk. May have regulatory minimum
  3. Alternative Investments: Low or negative correlation with traditional
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18
Q

Sovereign Wealth Types (List)

A

BD_SRP (São José Rio Preto)

  1. Budget Stabilitzation Funds
  2. Development Funds
  3. Savings Funds
  4. Reserve Funds
  5. Pension Reserve Funds
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19
Q

Sovereign Wealth Types (Describe)

A
  1. Budget Stabilization Funds: Prevent budget from commodity volatility and external shocks.
  2. Development Funds: socioeconomic projects, mainly infra
  3. Savings Funds: share wealth across generations. Transform non-renewable assets into diversified financial assets
  4. Reserve Funds: Reduce negative carry costs of holding reserves
  5. Pension Reserve Funds: Meet future outflows (shortfalls)
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20
Q

Sovereign Wealth Funds Stakeholders (List)

A
  • Government
  • Citizens
  • External Asset Managers
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21
Q

Sovereign Wealth Liabilities (Describe per type of fund)

A
  1. Budget Stabilization: Uncertain liabilities. Short IH.
  2. Development: Uncertain liabilities. Medium to long IH.
  3. Savings: Long liabilities. Long IH.
  4. Reserve: Liabilities are the Central Bank monetary stabilization bonds. Long IH.
  5. Pension Reserve: Liabilities are pension-related. Long IH.
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22
Q

Sovereign Funds Liquidity Needs (List per Type)

A
  1. Budget Stabilization: ↑ Liquidity
  2. Development: ↓ Liquidity
  3. Savings: ↓ Liquidity
  4. Reserve: Entre Savings e Budget
  5. Pension: ↑ need in accumulation or ↓ need in decumulation
23
Q

Sovereign Wealth Fund External Constraints (List)

A

LETA

  • Legal and Tax: national legislation
  • Tax and Accounting: Tax-Free is defined by legislation (not necessarily national)
24
Q

Sovereign Wealth Funds Investment Objectives (List / Type)

A
  1. Budget Stabilization: Capital Preservation. Return > π.
  2. Development: Real rate of return > real GDP or productivity growth
  3. Savings: Maintain PP of assets and achieve returns to sustain govt spending
  4. Reserve: Monetary stabilization. Achieve rate of return above govt stabilization bonds
  5. Pension: Returns to maximize likelihood of being able to meet future unfunded pension liabilities.
25
Q

Sovereign Wealth Funds Allocation (List / Type)

A
  1. Budget Stabilization: FI & Cash
  2. Development: Equity, FI, AI
  3. Savings: Growth Assets (Equities, AI)
  4. Reserve: Equity, FI, AI ( ↓ Equities / ↑FI )
  5. Pension: Large Equity, 10-15% AI

Conservative: Budget Stabilization > Reserve > Pension
Return-seeking: Development > Savings

26
Q

Endowments and Foundations (Describe)

A

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)

27
Q

Endowments and Foundations Stakeholders (Describe)

A
  • Current and Future Students (PUC)
  • Alumni (PUC)
  • Current and Future Faculty Administrators (PUC)
28
Q

Endowments IH and Liabilities (Describe)

A

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.

29
Q

Endowment Spending (Formula)

A

Spending t+1 = w[Spendingt*(1+π)] + 1-w[Spending rate * AUM]

w = market value rule weight
1-w = constant growth weight

30
Q

Endowment Return Requirement (Concept)

A

Since the aim is to maintain purchasing power, target a real return ≥ spending rate

31
Q

Foundation Investment Horizon and Liabilities (Describe)

A

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
32
Q

Foundation Main Characteristics (List)

A
  1. Required to spend 5% of AUM + Investment Fees or pay taxes
  2. May be able to issue debt
  3. Rely on their own returns to support its operating budgets. Hold LESS illiquid assets than endowments.
  4. Low liquidity needs (net spending of at least 5% of AUM + Inv fees)
33
Q

External Constraints

A

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

34
Q

Endowments v. Foundation Investment Objectives (Differentiate)

A

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

35
Q

Endowment Asset Allocation (List)

A

↓ Size = ↑ FI and ↑ Equity
↑ SIze = ↑ Alternative Investments

36
Q

Banks Stakeholders (List)

A

External: Shareholders, Creditors, Customers, Credit Rating Agencies, Regulators

Internal: Employees, Management BoD

37
Q

Banks Assets and Liabilities (List)

A

Assets: Loans, Debt Securities
Liabilities: Deposits (Time Deposits = CDB datado, Demand Deposits, short duration), Wholesale Funding

38
Q

Banks Investment Horizon and Liquidity Need (Describe)

A
  • Perpetual life
  • Short to medium duration
  • Potential need for increased liquidity (LCR and NSFR)
39
Q

Insurance Stakeholders (List)

A

External: Shareholders, Derivative Counterparties, Policyholders, Creditors, Regulators, Rating Agencies

Internal: Employees, Management, BoD

40
Q

Insurance Liabilities (List)

A

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.

41
Q

Insurance Liquidity Needs (List)

A

Life: Disintermediation. ↑ Rates = People terminate insurance policies = ↑ Liquidity Requirements.

Property & Casualty: ↑ Liquidity needs because it is uncertain

42
Q

Insurance Investment Portfolio Components (List)

A
  1. Reserve Portfolio (meet policy liabilities)
  2. Surplus Portfolio (intended to realize higher returns)
43
Q

Insurers Constraints

A
  • Legal / Regulatory: Capital Adequacy, Liquidity, Leverage
  • Tax / Accounting: Standard Financial Accounting (IFRS, Gaap), Statutory (Regulators), True Economic Accounting (MTM of Assets and Liabilities)
44
Q

Bank Investment Objectives (List)

A

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

45
Q

Insurer Investment Objective (List)

A
  • Manage investment portfolios with a focus on liquidity
  • Grow surplus over time (sensitive to any loss of principal or interruption in investment income)
46
Q

Banks / Insurers Duration Mgmt (Formula)

A

(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

47
Q

Banks/ Insurers Duration Mgmt (Formula)

A

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

48
Q

Duration Management Formula in terms of Correlations (Formula)

A

(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]

49
Q

Conclusions on Duration Management (List)

A

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

50
Q

Effect of Prepayment Penalties on Equity (Rationale)

A

↑ Prepayment Penalties = ↑ p (correlation)

Rationale: ↓ i = ↑ Prepayment = ↑ Risk of Refinancing. Penalties help to maintain them for more time.

51
Q

Effect of catastrophic insurance risks on Equity (Rationale)

A

Insurance Risk = ↑ΔL/L

Rationale: Higher risk of uncertain liabilities

52
Q

Items impacting ΔL/L

A

1) Catastrophic Insurance Risk = ↑ΔL/L
2) Derivatives transparency = ↓ ΔL/L
3) Surrender penalties = ↓ ΔL/L
4) Predictability of underwriting losses: ↓ΔL/L

53
Q

Items impacting ΔA/A

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

CFA L3 Matheus (18 decks)

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