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CFA Exam Level 3 > Institutional Investors > Flashcards

Institutional Investors Flashcards

1
Q

5 Common Characteristics of Institutional Investors

A
  1. Scale (Size)
  2. Long-Term Investment Horizon
  3. Regulatory Framework
  4. Governmental Framework
  5. Principal Agent Issues
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2
Q

IPS of Institutional Investors Should Include

A
  • Mission and Investment Objectives Return and Risk Tolerance
  • Discussion of the time horizon and liabilities as that need to be paid off
  • Any External Constraints: Legal, regulation, taxation, and accounting
  • Asset Allocation Policy: ranges, weights, and asset class benchmarks
  • Rebalancing Policy
  • Reporting Requirements
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3
Q

Approaches to Asset Allocation

A
  1. Norway Model
  2. Yale Model “Endowment Model”
  3. Canadian Pension Plan Model
  4. Liability Driving Investment
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4
Q

Norway Model

A
  • 60% equities and 40% bonds
  • Passive allocation to public securities
  • Little to no exposures to alternatives
  • Tight tracking error limits
  • Advantages: Lowest costs and fees, easy for communication
  • Disadvantages: Passively managed, no opportunities for outperform the markets
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5
Q

Yale Model

A
  • High allocation to alternatives; around 50%
  • Assets are managed externally
  • Advantages: Potential to outperform the markets (actively managed)

Disadvantages:
* Difficult for a smaller institutions to implement
* Higher fees and costs
* Difficult for larger management due to limits of capacity

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6
Q

Canadian Pension Plan Model

A
  • High Allocation to Alternatives
  • Significant amounts of active management
  • The assets will be managed internally and due diligence
  • Ability to outperform the market
  • Disadvantages: More expensive and difficult to manage
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7
Q

Liability Driven Model

A
  • Maximize the surplus
  • Management limits the volatility of the surplus
  • Taken into account the liability
  • Longevity risks is difficult to hedge (lifespans)
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8
Q

Defined Benefit Plan (DB)

A
  • Less prevent, traditionally set up a legal entity with a trust
  • Must hire an actuary to determine the benefits due
  • Assume risks if not enough funds
  • Surplus: Any additional can be used to pay for other expenses such as an actuary
  • Longevity Risks
  • Plan sponsor makes contributions to plan
  • Comparing FMV of assets by the projected benefit obligation “PBO” (PVDBO IFRS)
  • Gives the economic status of the plan, must be placed on the balance sheet
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9
Q

Considerations that Drive the Risks Tolerance for a DB Plan

A
  • Plans funded status
  • Sponsors Financial Status
  • The size of the plan compared to the sponsor
  • Common risk exposure
  • Any provisions for early retirement “lump sum distributions:
  • Workforce characteristics
  • Correlations between the sponsor and plan assets
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10
Q

Liquidity Needs of a DB Plan

A

Liquidity needs are generally higher if:
* The workforce is older
* Larger proportion of relived lives in the plan that are receiving benefits
* Lower the Funded Status Plan
* If there is a provision to withdraw or switch from the plan

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11
Q

Investment Objective of a DB Plan

A

Primary Objective: Achieve a target rate of return over a long-term investment horizon to maintain a level of risk consistent with their contracted liabilities

Secondary Objective: Might not be for every plan. Could be to minimize the cash contributions that the plans sponsor has to make, in present value terms PBO > Plan assets

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12
Q

Discount Rate Change of a DB Plan

A

Higher Discount Rate: Reduces the present value of the liabilities (PBO) and would reduce the need for sponsor contributions to the plan (raises the funded status)

Lower Discount Rate: Increases the present value of the liabilities (PBO) and would increase the need for sponsor contributions to the plan (lowers the funded status)

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13
Q

Defined Contribution (DC) Plans

A
  • Employee saves for retirement and the employer could match an amount
  • Very little accounting by the employer
  • Performance risk is born by the employee
  • Metrics of outperformance any kind is to a passive benchmark or default option
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14
Q

Sovereign Wealth Funds Categories

A

Investment funds owned by a government there are 5-broad categories:
* Budget Stabilization Funds
* Development Funds
* Savings funds
* Reserve Funds
* Pension Reserve Funds

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15
Q

Sovereign Wealth Funds - External Constraints

A

Establish by law, gives the mission structure to avoid political influence they need
* High Quality Governance
* Independent
* Transparency
* Accountability

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16
Q

Santiago Principal

A

Best principal framework that address the external constraints

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17
Q

Budget Stabilization Funds

A
  • Set up when a countries revenues are heavy linked to a natural resources or cyclical industries
  • Main Objective: Insulate the budget and economy from commodity price volatility, economic cycles, and external shocks.
  • Liquidity Needs: Maintain the highest level of liquidity and invests in assets of low risk in order to meet short-term deficits created by negative economic situation.
  • Invest In: Cash and fixed income; has high liquidity need
18
Q

Development Funds

A
  • For national social economical projects that support key industries
  • Main Objective: Fund priority socioeconomic projects.
  • Liquidity Needs: Longer-term, Low Liquidity needs
  • Invest In: Local infrastructural projects; long-term
19
Q

Savings Funds

A
  • Invest revenues for the benefits of future generations.
  • Main Objective: Fund pension-like liabilities of the government
  • Liquidity Needs: Are low, but increase when the government withdrawals from the funds
  • Invest In: Equities, Private Equity, and Real Estate
20
Q

Reserve Funds

A
  • Created or designed to earn returns on excess foreign reserves held by central banks.
  • Main Objective: To increase returns or reduce the negative carrying costs of government reserves.
  • Liquidity Needs: Generally, hold liquid fixed income securities, asset sold pretty easily
  • Invest In: Equities, Private Equity, and Real Estate, but it has a higher liquidity needs so, the alternative allocation will be less than the savings funds
21
Q

Pension Reserve Funds

A
  • Used to save and invest in order to meet any future pension liabilities
  • Main Objective: Is to share wealth across generations usually to high revenues from nonrenewable assets (oil reserves).
  • Liquidity Needs: Various; lower duration the accumulation stage and higher during the payment stage
  • Invest In: Higher Allocations to equities and alternatives due to long investment horizons and lower liquidity needs.
22
Q

University Endowment

A
  • Set up by gifts and donations which are invested to provide ongoing support to the operating budget
  • 10% of operating budget is consider low while 40-60% is high; this effects the risk tolerance
  • The time horizon is in perpetuity
  • Most large universities will follow the endowment model alternatives (>50%)
  • Smaller universities will invest with a home bias; normally in equities and fixed income
  • Normally they have a tax-exempt status and maintain conditional rules
  • Liquidity needs are usually 2-4% it is the annual spending net of gifts and donations
23
Q

The Endowment Spending Policy

A

Integration of equity while smoothing payouts to integrate with volatility.

The dollar amount of spending each year is a weighted average of 2 components
* Their previous years spending adjusted for inflation
* Spending rate (real rate, usually 3-4%) applied to among average of AUM

In general, the spending rate for the endowment is about 5%

24
Q

The Endowment Spending Rules

A

A. Constant growth rule (w=1): The endowment is providing a fixed (real) annual payout of the university adjusted for inflation. The percentage of endowment (pays out) will fluctuate with value of the assets.

B. Market Value Rule (w = 0): Procyclical the spending will fluctuate in line with the moving average of AUM

C. Hybrid Rule (0 < w < 1): A weighted average of the other 2 rules

25
Q

Intergeneration Equity

A

Balance the needs of today with the needs of the future

26
Q

The Investment Objective of an Endowment

A
  • Primary: To achieve a total real rate of return (after inflation) of at least a certain percentage with a reasonable level of risk. (5% general real return)
  • Secondary: Outperform a benchmark or similar peer group of endowments
27
Q

Private Foundations

A
  • Generally non-profit institutions that have been set up to make grants in order to support specific charitable causes.
  • Main objectives: To maintain the purchasing power in perpetually and support their grants
  • Liabilities and investment horizon normally perpetually in nature
  • Most large foundations will follow the endowment model alternatives (>50%)
  • Smaller foundations will invest with a home bias; normally in equities and fixed income
  • The USA requires foundations to pay out a minimum 5% of asset plus investment expenses on a trailing 12-month basis
  • Flowthrough Method: Foundations must spend any donation they receive in the year they receive it
  • Tax Exempt, if they fail to meet the spending requirements, they will lose their tax-exempt status (30% tax on any undistributed income)
28
Q

Investment Objectives of Private Foundations

A
  • Primary: to earn a real rate of return over inflation (minimum 5%) plus investment expense and maintain the volatility in a reasonable range 10-15% over a 3-5 year period
  • Secondary: Outperform a benchmark
29
Q

Banks

A
  • Return Objectives: Earn a profit from taking deposits from savers and making loans to borrowers
  • Function: Save guarding assets, executing transactions, and advising in securities & derivatives
  • Demand Deposits: can be withdrawn without any notice.
    Time Term Deposits: (CDs) require advance notice before withdrawls
  • Horizon: Will be influenced by the difference between the long-term asset and short-term liabilities
  • Need a certain liquidity coverage ratio must have an adequate capital level in different stable sources
  • Primary Objective: Is to manage liquidity and reduce any mismatch risks
  • Adequate capitalization: So, they can absorb losses and not become insolvent
30
Q

Different Accounting Systems for Banks

A
  • Standard Financial Reporting: (GAAP & IFRS) used to communicate results to shareholders through their financial statement
  • Statutory Accounting: Used by regulators making series of adjustment to the accounts more conservatives, might force banks to remove intangible assets from the balance sheet, force accrued expenses or losses, or recognizing reserves
  • True Economic Accounting: Market values for all assets and liabilities
31
Q

Insurance Companies

A

Insures can be divided into
* Life Insurance: who provide products such as annuities, whole, variable, universal, GICKS, and term
* Property and Casualty Insurer: Write insurance to commercial, residential, cars, and others

32
Q

Liquidity Needs for Insurance Companies

A

Effected by the Level of Interest Rates: When interest rates are rising or in a high interest rate environment policy holder with a low yield instruments will surrender or cash in their policy in order to invest in a higher yielding investment.

33
Q

Property and Casualty General Accounts

A

Generally, divides their general account investments into 2 components:
* Reserve Portfolio: Regulations requires insurance companies to meet any policy labilities as they come due (Invest mainly in fixed income)
* Surplus Portfolio: Anything not in the reserve portfolio invested in higher risk securities to earn a higher return (Stocks and alternatives)

34
Q

Interest Rate Risk for a Bank

A

A major risk to the capital of a bank or insurer is its interest rate exposure.
Higher interest rates will reduce the value of many of the balance sheets assets (loan book, fixed-income securities) and liabilities (deposits, future insurance claims) that are mostly interest rate–sensitive.

35
Q

Volatility Measures of Capital Risk

A

Thinking of equity capital as a two-asset portfolio of assets (A) and liabilities (–L), we can calculate the variance of the return on equity capital by incorporating the standard deviations of the return on assets and liabilities, the correlation of these returns and the amount of leverage.

The higher the leverage, the higher the capital volatility.

36
Q

How to Reduce the Volatility of Shareholder’s Equity

A
  • Reducing the Volatility of its Assets (can reduce volatility of equity)
  • Reducing the Volatility of its Liabilities (can reduce volatility of equity)
  • Diversifying its assets and liabilities
  • Increase the correlation of its assets and liabilities
  • Reducing its financial leverage (debt)
  • Accessing stable funding sources
  • Increasing the quality and liquidity of its investment asset
37
Q

Spending Amount Formula

A

“Yale Formula”
* Is an example of a geometric smoothing rule, (intended to bring about a predictable pattern of distributions)
* Long-term returns that support the spending rate while preserving the value of the endowment in real terms over time
* Design also incorporates a smoothing, countercyclical element.
* Leads to lower spending rates in a period of sustained strong investment returns but higher spending rates in a protracted weak return environment.

38
Q

Size/Scale Issues:

A

If the size of the investment team is small
* May not have adequate access to or experience in alternative investments.
* Unlikely that it has access to top managers in the hedge fund and private equity spaces.
* This can affect any type of investor or institution

39
Q

Risk Profile “Drift”

A
  • Illiquid assets carry extremely high rebalancing costs.
  • Have sufficient liquid assets and rebalancing mechanisms in place to ensure the portfolio’s risk profile remains within acceptable risk targets and does not “drift”
  • Must ensure an effective rebalancing mechanism is adopted prior to the investment and is consistently followed thereafter.
  • That mechanism can either be through a systematic discipline, such as calendar rebalancing or percent-range rebalancing
40
Q

Shortfall Risk of a DB Plan

A

Lower:
* Smaller Asset/Liability Risk Mismatch
* If duration is matched of fixed income investments with the duration of pension liabilities, the firm with the highest allocation to fixed income in the DB plan.

Higher:
* Lower defined benefit plan surplus as a percentage of plan assets
* Lower relative funding surplus

41
Q

How to Lower Cost of Equity Capital

A
  • While using a full economic balance sheet, shifting the pension plan’s portfolio from equity into fixed income.
  • The beta of the firm and the beta of equity capital would also decrease.
  • Investors would require a lower return based on decrease risks.

CFA Exam Level 3 (13 decks)

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