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FINM3008 > 2. Types of investors and their objectives (Week 2) > Flashcards

2. Types of investors and their objectives (Week 2) Flashcards

1
Q

65 years old retiree

  • Single, no children, healthy and active
  • Live a comfortable lifestyle
  • Renting, no mortgage, no credit card debt
  • Only asset is $5 million cash in deposit account with NAB

what are the risks?

A
  • unlikely to have high inflation to erode wealth.
  • bankrupty of NAB

-

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2
Q

Ways in which investors can differ

Objectives

Risk preferences

Investment horizon

Investor circumstances

Business or personal considerations

A

receive company shares as part of bonus or incentive

tied up with same company .

diversify away from your company

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3
Q

Ways in which investors can differ

Objectives

Risk preferences

Investment horizon

Investor circumstances

reference portfolios

A

relevant for portfolio managers

benchmark to evaluate portfolio manager’s performance. Risk averse as portfolio managers. not too different from industry norm.

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4
Q

Ways in which investors can differ

Objectives

Risk preferences

Investment horizon

Investor circumstances

•need for liquidity or ‘immediacy’

A

need cash from their fund

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5
Q

Ways in which investors can differ

Objectives

Risk preferences

Investment horizon

Investor circumstances

A
  • need for liquidity or ‘immediacy’
  • costs – management fees, transaction costs, taxation, etc
  • reference portfolios – legacy portfolio; ‘background’ assets like human capital, residential property
  • business or personal considerations, e.g. career
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6
Q

Ways in which investors can differ

Objectives

Risk preferences

Investment horizon

•holding period vs. review period why?

Investor circumstances

A

Regularly review of portfolio performance give you chance to new changes of life and investment opportunities.

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7
Q

Ways in which investors can differ

Objectives

Risk preferences

Investment horizon

•holding period vs. review period

Investor circumstances

A

Holding period = entire investment horizon . 30-40 years of investment horizon

Review period = regularly check portfolio performance over certain period

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8
Q

Ways in which investors can differ

Objectives

Risk preferences

Investment horizon

Investor circumstances

A
  • holding period (entire investment horizon) vs. review period
  • dynamics, i.e. investing over more than just one period
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9
Q

Ways in which investors can differ

Objectives

Risk preferences

Investment horizon

Investor circumstances

A

Will continue until we do not need funds from superannuation

can be indefinite e.g. family trust. providing trust flow for future generations

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10
Q

Ways in which investors can differ

A

Objectives

Risk preferences

Investment horizon

Investor circumstances

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11
Q

Australian pension funds have

A

offered Defined benefit funds to defined contribution funds in the last 20 years

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12
Q

DB funds calculation

A

e.g. uni super

based on age

years of service

how much you’ve contributed

your salary over 5 years

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13
Q

Defined contribution Funds

features

A

make regular contribution. manage asset allocation in super account by yourself

when you retire, take what is in super account.

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14
Q

DB Fund

Risk

A

Chance the fund is not able to meet liability payment

value of total assets and value of liabilities. Difference measures the risk. Larger the difference, fund is in deficit and in trouble

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15
Q

DB Fund Objective

A

meet liability

benefits payout obligation for retiring members

investment horizon is indefinite

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16
Q

DC Funds Objective

A

Some may want to use it to payout their mortgage when they retire

set up family trust to benefit future generations

set up retirement living

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17
Q

How do portfolio managers manage DC Funds

A

Given benchmark. I invest in High growth in diversified portfolio product.

This portfolio manager will be given a benchment e.g.

Average performance of all of the high growth superannuation funds in Australia.

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18
Q

How do portfolio managers manage DB Fund

A

manage the gap

asset allocation decision: improve situation of fund. If there is deficit, try to reduce the deficit.

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19
Q

insurance companies

Put collected premium and put in investment fund

objective

A

Meet policy holders. Meeting liabilities

generate return as profit. impact of profit

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20
Q

Endowments & Foundations

Objectievs

A

certain programs to support e.g upgrade IT system, build library.

That will depend on income. Return greater than long term inflation

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21
Q

Fund managers

objective

A

e.g. retail mutual funds, colonial first state

concerned with profit of the fund and concern of the relative performance e.g. published by morning star and internal ranking of their performance. Under constant pressure to outperform.

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22
Q

Private investors incl SMSF

Objective

Risk

•

•70-year old retired surgeon

–Self-funded retiree

–Own house (paid off)

–Live a very comfortable lifestyle ($65,000/year)

–Superannuation $5 million

Other assets $15 million

A

is 5m enough for them to live with for the rest of their life

Not able to finance him the rest of his life

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23
Q

Private investors incl SMSF

Objective

Risk

•70-year old retiree

–Government pension

–Renting

–Live a modest lifestyle ($20,000/year)

–Total assets of $20,000 cash from inheritance

–Need $1,000 cash every year for a chronicle disease treatment

A

Generate 5% return P.a

Not being able to fund that

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24
Q

Definition Risk

A
  • Risk as the possibility of an adverse outcome
  • An adverse outcome as failure to meet objectives
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25
Q

Corporate Super DB Fund

Objective

Investment horizon

A

meet the benefits payment requirement (liability) of its members

•on-going, indefinite

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26
Q

Corporate Super DB Fund

difference from DB Fund

A

Profit target for managers, executives and board of directors

anything you take from the pocket of shareholders will go to DB Fund to form part of assets.

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27
Q

Corporate Super DB Fund

asset allocation decision

member

A

produce a perfect match

just need to be paid retirement funds

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28
Q

Corporate Super DB Fund

asset allocation decision

Executives

A

Board of DB Fund, they have own performance pressure e.g. total shareholder return, profitability target

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29
Q

Corporate Super DB Fund

asset allocation decision

sponsoring entity(the company)

A

Push for higher asset allocation to growth assets = higher expected returns, higher expected future incomes and higher chance of meeting future liability of the fund

BUT HAVE TO CONSIDER

higher volatility between assets and liability. high deficit. High difference between asset and liability. Another GFC, huge deficit b/c of asset allocation of 80% growth assets

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30
Q

Corporate Super DB Fund

asset allocation decision

A

is the outcome of “negotiations” among all stakeholder who have distinct objectives.

üSponsoring entity (the company)

üMembers

üPortfolio managers

üGovernment

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31
Q

Corporate Super DB Fund

members

A

Employees, union, company management eg CEO, members of DB Fund

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32
Q

Corporate Super DB Fund

Risk is defined by

A

difference between value of assets and value of estimated benefits Net PV of future benefits payout

that is for the fund

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33
Q

What is the asset allocation decision

A

To predict to relevant risk

e.g. allocating asset risk to manage the risk. higher chance of achieving objectives

the essence of investment management is the management of risk, not management of returns

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34
Q

how to measure risk for objective

Others - regret

A

probability of wrong choice

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35
Q

how to measure risk for objective

Relative Benchmark aka peer risk

A

Tracking error. How much you deviate from industry norm of asset allocation

200 index as benchmark. your asset allocation decision will help you meet that benchmark or perform as well.

Sometimes portfolio managers will take additional risk by allocating assets away from benchmark.

if there is 25% asset allocation with ASX 200 in banking sector, if you are embarrassed with banking sector given recent renovation by banking commission and want to allocate in portfolio of 20% or 15% in banking sector in your own portfolio.

Generating substantial peer risk. Other portfolio managers in the industry are allocation 25% and you are allocation 15%. if you are right

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36
Q

how to measure risk for objective

Absolute target return

A

objective by fund manager

e.g. 3% excess return above inflation using inflation as benchmark or 1% above australian equity funds in the market. difference of portfolio performance and benchmark will be the risk measure

Shortfall

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37
Q

how to measure risk for objective

Suppot spending programs for endowment funds

A

Shortfall

difference between desired spending and income generated by endowment funds

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38
Q

how to measure risk for objective

Consumption in retirement

A

Shortfall

difference between desired consumption and available superannuation income stream

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39
Q

how to measure risk for objective

Profit impact

A

profit volatility

any contribution made by sponsoring entities for company is taken from the profit available for distrubition to shareholders

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40
Q

how to measure risk for objective

Meeting liabilities

A

surplus volatility/shortfall

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41
Q

how to measure risk for objective

Maximize E[U(W)]

A

Maximise utility of wealth

•Asset/portfolio volatility (drops)

especially the downside

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42
Q

Issues with quantitative risk measures

Characterising the distribution

parametic vs non-parametric

A

We do both to have better understanding of risk

parametic (Model-based) have certain assumptions that return follows certain assumptions e.g. standard deviation.

vs

non-parametric (Data-based)

  • don’t care about distribution of returns; only focus on data i have. Calculate the probability of loss. don’t care about Z score or confidence interval. don’t assume they follow assumptions
  • rely on data, over different period, different numbers of quantitaitve measures of risk eg probability of loss
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43
Q

Issues with quantitative risk measures

•Matters that cannot be easily incorporated

Personal

A

personal assets .g. human capital, family home

difficult to quantify or assess

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44
Q

Issues with quantitative risk measures

•Matters that cannot be easily incorporated

Funding or

A

funding or cash flow uncertainty and illiquidity risk

  • Funding or cash flow uncertainty

DB Funds, endowment or charity funds e.g. major blow of contribution. have to change their asset allocation to meet the expected expenditure. have to deal with other damages of the risk associated with the funds.

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45
Q

Issues with quantitative risk measures

•Matters that cannot be easily incorporated

Risks

A

–Business risk (bankrupty risk), personnel risk, counterparty risk, governance-related failures, changes in public policy

  • very hard to forecast these
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46
Q

Issues with quantitative risk measures

•Matters that cannot be easily incorporated

black swans

A

possibilities in extreme markets (‘black swans’)

e.g. cannot predict GFC on australian economy

cannot be incorporated into quantitative measures of risk. rare to forecast another GFC

47
Q

Issues with quantitative risk measures

•Characterizing the distribution

  • Investment horizon
  • investment horizon is monthly v 10 years
A

short long term horizon:

  • sell portfolio after 1 month
  • bear loss in short period. within a month, more likely to experience momentum. and unlikely to have mean reversion
  • very volatile goes negative

every month calculate portfolio returns for past 10 years. any loss i made in early years are recouped.

long term mean reversion: asset returns convert to their long term mean. expected return of assets is positive

48
Q

Issues with quantitative risk measures

•Characterizing the distribution

  • Instability in return generating process

using recent and old data

A

early 1980s - all the regime of monetary policy into quantitative analysis and part of it will distort risk analysis e.g. volatility. Might include something irrelevant for future

Try to include recent period: using most recent, lose data points. Yearly data interval, past 10 years, have 10 data points. difficult to run quantitative analysis

49
Q

Issues with quantitative risk measures

•Characterizing the distribution

–Instability in return generating process

A

structural change in early 1990s. double digit mortgage

50
Q

Fundamental risk approach

A
  • Any factor to which the overall portfolio is exposed
  • Also consider: liabilities, illiquidity, home bias, systemic risks
51
Q

Fundamental risk approach

Economic risk

A

all assets you hold in australia is subject to economic risk

52
Q

Characteristics of illiquidity risk

A
  • Illiquid assets typically cost more to transact – result in an ugly “haircut”
  • Illiquidity can result in a failure to transact – result in an undesired “perm”

“haircut”: sell for big discount to attract buyers, end up with an ugly haircut.

“perm”: can’t transact, stuck with what you have, end up with perm;

  • True asset value is often unknown
  • Historical performance may be misleading
  • Illiquidity risk is systematic; liquidity can be absent when most needed - like taxi in a storm
53
Q

Characteristics of Illiquidity

A

•Illiquidity has investor-specific implications

− time horizon

−need for immediacy

−tolerance for sub-optimal portfolio

−discretion over sale

54
Q

Illiquidity Risk Management

Managing Illiquidity Risk – Evaluation

Region

  1. Trading necessary and infeasible
A

Sub-optimal portfolio unavoidable

Potential dire consequences, e.g. business survival

55
Q

Illiquidity Risk Management

Managing Illiquidity Risk – Evaluation

Region

  1. Trading necessary and feasible
A

Cost of transacting unavoidable, and open-ended

Risk compounded if trading is more likely to become mandatory when it is most costly

56
Q

Illiquidity Risk Management

Managing Illiquidity Risk – Evaluation

Region

  1. Trading desirable and feasible, but costly
A

Implication

Investor has the option to trade

Effective cost reflects minimum of:

  • Cost of transacting
  • Cost of persisting with sub-optimal portfolio
57
Q

Illiquidity Risk Management

•“Risk Management Cycle”

A

–Understand the context

–Identify the risks

–Evaluate the risks

–Address the risks

–Monitor the portfolio

58
Q

Illiquidity Risk Management

A

•Illiquidity risk is complex to analyze, but it doesn’t mean that investors should avoid illiquid assets altogether because illiquid assets do provide diversification benefits and additional source of returns to portfolio

59
Q

the reference portfolio

A

benchmark for performance evaluation

60
Q

Relative Risk: peer risk and regret

A

Example: The reference portfolio (benchmark for performance evaluation): a balanced portfolio of 60% equity and 40% bond. Within the equity bucket, 50-50 for domestic vs world equity.

Portfolio manager’s decision on the allocation of funds into domestic and world equity plays an important role in the portfolio performance over different investment horizons.

The average performance difference is -5% for the period before 2000, 5% for the period after 2000. Long term average is very close to zero.

61
Q

Liability-driven Investment Management

•Strategies

A

–Strategic and dynamic asset allocation

–Derivatives

–Special purpose vehicles

–Annuity contracts

–Reinsurance

–Managing liabilities

62
Q

Liability-driven Investment Management

••Emerging risks

A

–Longevity risk, inflation risk, operational risk, legislative risk

63
Q

Liability-driven Investment Management

•Immediate risks

A

–Interest rate risk, market risk, assumption risk

64
Q

Which of the following statements about illiquidity is correct?

A

Illiquidity risk is idiosyncratic; i.e. a systematic risk that requires compensation for bearing such a risk

  • non-diversifiable. depends on investor time horizon
65
Q

Which of the following statements best describe the risks for a 65 years old retiree with $1 millin cash in savings account as the only financial resource for her retirement?

A

ASX 200 index volatility.

B

The looming property market slump in major Australian cities, such as Sydney and Melbourn.

C

Interest rate risk, ie. the possiblity of the Reserve Bank of Australia lowering target interest rate given the current challenges in the economy. This would put downward pressure on the interst rate in the retail market. There’s a chance that the income from her savings account is not enough to support her retirement.

D

The possiblity of bankrupcy of the bank where she holds her savings account. If this happen, she would have to suffer from substantial financial loss and the recovered amount would not be enough to support her retirement.

E

The possiblity that the savings account is in shortfall to support her desired lifestyle in retirement.

A

C

Interest rate risk, ie. the possiblity of the Reserve Bank of Australia lowering target interest rate given the current challenges in the economy. This would put downward pressure on the interst rate in the retail market. There’s a chance that the income from her savings account is not enough to support her retirement.

D

The possiblity of bankrupcy of the bank where she holds her savings account. If this happen, she would have to suffer from substantial financial loss and the recovered amount would not be enough to support her retirement.

E

The possiblity that the savings account is in shortfall to support her desired lifestyle in retirement.

66
Q

Select all of the correct statements about “risk” in fund management.

A

Risk is simply measured as the standard deviation of returns for any portfolios.

B

Risk is linked to investor’s objectives.

C

Risk is linked to investment horizon, eg. the standard deviation of unlisted property fund tends to understate the true risk over short run.

D

Risk is the undesired outcome that investor’s objective is not achieved.

E

All risks can be quantified using statistical measures.

A

B

Risk is linked to investor’s objectives.

C

Risk is linked to investment horizon, eg. the standard deviation of unlisted property fund tends to understate the true risk over short run.

D

Risk is the undesired outcome that investor’s objective is not achieved.

67
Q

Which of the following funds have the primary objective as meeting liabilities?

A

A direct property fund with a leverage ratio of 80%

B

A defined benefit superannuation fund

C

A SMSF of a 35 years old bank employee

D

A defined contribution superannuation fund

E

An endowment fund of a university

A

A defined benefit superannuation fund

68
Q

Which of the following investors is most likely to be concerned about peer risk or tracking error risk?

A

Fund manager of a retail Australian equity fund

69
Q

Why is DB Fund and Investment company not concerened about peer risk or tracking error risk?

A

B

Insurance company. Every insurance fund have their own particular position of liability

Genreate wealth to maximise wealth of company but DB funds do not have

No benchmark. Each DB fund is special. It is in its own position of expected forecasted liability

70
Q

DC funds have a

A

benchmark portfolio to assess their performance or given an absolute return.

71
Q

how do DC funds have shortfall?

A

shortfall = difference between portfolio return and benchmark

within uni super lots of products, balanced portfolio within accumulated division, may be given absolute return e.g. 3% above long term inflation, sometimes 6%.

72
Q

DC funds concerned with skewness b/c

A

skewness indicates downside risk. concerned with the tail risk. skewness of total portfolio return.

73
Q

How does shifting to 5-years change the risk measures?

A

Distribution of rate of (per annum) returns narrows (SD reduces from 14.6% annually to 6.2% over 5 years), and so does the probability of lower returns (reduces from 17.6% annually to 5.9% over 5 years)

74
Q

Another important issue involves whether to manage the fund’s asset class investments passively or actively.

Active management

what must you consider

A

The higher expected returns of active management must be weighed against the associated additional risk and incremental cost

75
Q

Another important issue involves whether to manage the fund’s asset class investments passively or actively.

Active management

A

attempt to exceed the performance of a given index

76
Q

Another important issue involves whether to manage the fund’s asset class investments passively or actively.

Passive management

A

You can choose either to seek to match the performance of a given index

77
Q

The S&P/ASX300 index alone is capable of explaining about

adding world equity

A

82% of the fluctuation in returns.

Adding world equities allows nearly 93% of variation to be explained.

78
Q

why is a typical balanced portfolio of 60 growth and 40 other assets poorly diversified

A

such portfolios are invested in only a subset of all assets in the economy.

About 85%-90% is held in financial assets (equities, listed property, fixed income, and similar assets within other investments such as hedge funds). Nearly 60% of assets reside in Australia.

79
Q

Why are such concentrated exposures observed in these portfolios? (financial assets and home bias)

Pursuit of returns

A

when investors desire higher returns, a typical response is to go for the ‘equity risk premium’. This motivates the high equity weightings in many portfolios.

80
Q

Why are such concentrated exposures observed in these portfolios? (financial assets and home bias)

Availability

A

The prevalence of listed equities and fixed income within portfolios occurs in part because they are very accessible, particularly relative to other assets in the economy

81
Q

Why are such concentrated exposures observed in these portfolios? (financial assets and home bias)

Liquidity

A

Liquidity – Many investors, most notably institutions, require a certain degree of liquidity to support portfolio rebalancing, asset valuation and redemption needs. Financial assets offer this liquidity.

82
Q

Long term investor will be concerned with

A

developments that might lead to an extended episode of poor returns,

Such episodes are usually associated with major fundamental events: The influence of two world wars, the debt-deflationary Depression years, the stagflation in the 1970s, and ‘valuation mean reversion’ after the tech bubble are all highlighted.

83
Q

A short-term investor sensitive to

A

A short-term investor sensitive to short-term fluctuations, threat of margin calls, etc might be concerned with the impact of large monthly movements in their portfolio.

For them, risk relates to any event that can cause a large decline in a short period of time.

84
Q

potential fundamental risks

A

Macroeconomic risks

Illiquidity

Risks of a structural or systemic nature

Home bias

85
Q

The relevance of this risk partly depends on time horizon. Why?

A

Episodes of heightened risk premiums typically play out over periods of less than a year, before confidence returns and markets revert.

86
Q

Home bias

A

concentrated exposures in local assets.

87
Q

Portfolios that are heavily invested in local assets are exposed to

A

the risk of ructions in one’s own country.

88
Q

Liability-Driven Investment (LDI) seek to manage the

A

volatility in the gap between the assets and liabilities of the fund.

89
Q

what can increase the gap between the gap between the assets and liabilities

A

changes in key parameters, such as interest rates, inflation or taxation can have a different impact on the present value of those assets and liabilities

90
Q

LDI-style strategies have been used by super entities where

A

entity is responsible for delivering defined benefits, particularly pensions, from a dedicated pool of assets.

91
Q

Individual benefits from DB funds typically depend on

A

on the member’s salaries near their date of leaving, their completed membership at that date and their reason for leaving

cannot be known in advance.

92
Q

The investment portfolio of the superannuation fund represents a pool of assets set aside to

A

pay these benefits when they fall due. The amount in the pool of assets at any time is determined by the level of contributions and investment income

93
Q

immediate risk - significant short term impact

Why is interest rate a risk in db dunds

A

will change the present value of the liabilities by causing the discount rate to change, and also that it will change the value of any fixed interest investments held in the portfolio.

94
Q

immediate risk - significant short term impact

why is market risk a risk for DB funds

A

risk of movements in investment markets (in particular equity markets). Movements in investment markets will affect asset values, but may also affect benefit liabilities

95
Q

Emerging Risks Emerging risks have the potential to have financial impact over time

Describe Inflation risk as an emerging risk

A

the risk that inflation is higher than assumed. This can be either wage inflation (in the case of estimating the defined benefit) or price inflation (in the case of pension obligations)

96
Q

Emerging Risks Emerging risks have the potential to have financial impact over time

Describe Legislative risk as an emerging risk

A

government changes legislation in a way that adversely impacts on the pension obligations

risk of tax changes

97
Q

Emerging Risks Emerging risks have the potential to have financial impact over time

Describe longevity as an emerging risk

A

Longevity risk - more payments need to be made

98
Q

partial immunisation form of LDI

A

trustee decides to dampen, but not fully hedge, the effects of the volatility of assets and/or liabilities.

For example, it is currently quite common for funds to use swaps and other derivatives to hedge the interest rate risk in their asset portfolio to match their liabilities, whilst leaving the majority of their assets in a return-seeking portfolio.

chosen where the costs of a full hedging (immunisation) programme are deemed to be too expensive

99
Q

Full immunisation is the classic form of LDI in which movements

downside

A

relatively expensive, in that assets dedicated to precise matching of liabilities are likely to be lower yielding (albeit with lower risk) than would be possible in a more broadly diversified portfolio.

100
Q

Full immunisation is the classic form of LDI in which movements

A

movements in the value of the liabilities are precisely offset by simultaneous changes in the value of the assets.

101
Q

DB v DC

Fees

A

DC plan: participants pay the investment fees and expenses

DB plan: employer pays

102
Q

DB v DC

Benefits promised

A

In DC, no employee is promised a stream of benefits or is assured of accumulating sufficient assets t retirement

103
Q

DB v DC

Type of fund DB

A

DB fund, there is a pooled pension fund

employees make contributions to their own accounts and invest in the varous investment vehicles on the platform. Employers run the platform for the employees

104
Q

What do DB Funds promise employees

A

that they will receive payments determined by their years of service and salary

105
Q

objective of DB Funds

A

sufficient return to cover projected liabilities

106
Q

How should DB Funds risk be assessed

A

plan’s surplus/deficit of assets versus liabilities

107
Q

In general, higher perceived wealth

A

translates into higher risk tolerance

particularly when they primarily acquired wealth from investment returns –> overconfidence in investment skills —> inappropriately tolerant of risk

108
Q

Impact of life cycle stage on an individual’s objectives and financial resources

Spending phase

A

reliance on investment income and assets to cover expenses –> diminished ability to accept risk

109
Q

Impact of life cycle stage on an individual’s objectives and financial resources

Consolidation phase

A

Middle to late stages of their careers, most individuals are earnings more than enough to cover expenses, financial wealth is building

investment horizon shortens, diminishing the ability to take risk

110
Q

Impact of life cycle stage on an individual’s objectives and financial resources

Accumulation phase

A

individual has long horizon and growing income, but financial net worth is typcialy small relative to liabilities and future needs

due to long horizon and earning potential, such individuals can take significant investment risk with funds not allocated to specific short-term goals

111
Q

higher wealth and longer investment horizon indicate

A

greater ability to take risk

112
Q

Why is liquidity a constraint to an individual’s objective?

A

individuals need highly liquid assets sufficient to meet normal living expenses in the near term plus emergency reserve equal to 3-12 months

113
Q

Why is liquidity a constraint to an individual’s objective?

A

individuals need highly liquid assets sufficient to meet normal living expenses in the near term plus emergency reserve equal to 3-12 months

FINM3008 (15 decks)

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