Chapter 3 Managing Institutional Investor Portfolios

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Chapter 3 Managing Institutional Investor Portfolios Powered By Docstoc
					     Chapter 3 Managing Institutional
           Investor Portfolios
• Major learning outcomes:
   – Formulate an investment policy statement for a defined-contribution
     plan, a foundation, an endowment, an insurance company, and a bank.
   – Contrast investment companies, commodity pools, and hedge funds to
     other types of institutional investors.
   – Evaluate the factors that affect the investment policies of pension
     funds, foundations, endowments, life and non-life insurance
     companies, and banks.
   – Differentiate among the return objectives, risk tolerances, liquidity
     requirements, time horizons, tax considerations, legal and regulatory
     environment, and unique circumstances of pension funds,
     foundations, endowments, insurance companies, and banks.
   – Compare and contrast the asset/liability management needs of
     pension funds, foundations, endowments, insurance companies, and
   – Compare and contrast the investment objectives and constraints of
     institutional investors given relevant data such as descriptions of their
     financial circumstances and attitudes toward risk.
   Defined-Benefit (DB) vs. Defined-
        Contribution (DC) Plans
• DB plans promise a certain benefit in the future,
  DC plans promise a certain contribution today.
• DC plans confer no future liability to the plan
  sponsor, in contrast to DB plans.
• DC plan participants bear investment risk, DB
  plan sponsor bears investment risk.
• DB plan participants bear risk of early plan
  termination. In a DC plan, participants own their
• DC plans are more portable if the participant
  changes jobs.
  Defined Benefit Plan Objectives and
• Risk tolerance governed by multiple factors.
   – Plan surplus (assets in excess of liabilities) – risk tolerance can
     increase with surplus, but need to accept risk declines.
   – Sponsor financial status – A sponsor with less debt and higher
     profits can accept more investment risk as shortfalls can be
     made up with additional contributions.
   – Common risk exposures between sponsor and plan – The lower
     the correlation between sponsor operating results and plan
     returns, the higher the investment risk tolerance.
   – Plan features – early retirement or lump sum options reduce
     plan duration and reduce risk tolerance.
   – Workforce characteristics – more risk can be tolerated by plans
     serving relatively young workforce and by plans with a higher
     ratio of active lives to retired lives.

  Defined Benefit Plan Objectives and
• Return objective is to achieve inflation-adjusted
  returns that adequately fund its pension liabilities.
• Constraints include:
   – Liquidity (difference between annual contributions and
   – Time horizon is long if plan is continuing, but average age
     of workforce is a consideration.
   – Taxes: Investment returns are tax exempt.
   – Legal and regulatory: Investment policies are governed by
   – Unique circumstances include sponsor financial condition
     and specific investment prohibitions.

   Investing Pension Plan Assets: Risk
• Primary purpose of plan assets is to fund
  future liabilities.
• Asset/Liability management is a primary
• Plan may set a risk objective relative to the
  volatility of the plan surplus.
• Risk can also be expressed as a threshold for
  shortfall relative to a specified funded status.

    Investment Policy Statements for
       Defined Contribution Plans
• Principal investment issues for sponsor are
  diversification (menu of plan options) and limits
  to investments in company stock.
• Sponsor’s IPS documents ways to meet fiduciary
  responsibility with regard to plan options and
  procedures to ensure that individual objectives
  and constraints can be met.
• Each plan participant is responsible for defining
  his/her own investment objectives and
   Hybrid Pension Plans and Employee
         Stock-Ownership Plans
• Hybrid plans seek to combine the best aspects of both defined
  contribution plans (portability of assets, administrative ease and
  understandability by participants) and defined benefit plans
  (benefit guarantees, awards for length of service, ability to link
  retirement income to a percentage of salary).
• In most hybrid plans, employer bears investment risk (as with a DB
  plan) but employee receives an understandable statement (as with
  a DC plan.)
• Employee Stock Ownership Plans (ESOPs) are ways of encouraging
  company share ownership by employees.
   – Regulations vary widely from country to country
   – Diversification of assets becomes an important consideration for ESOP

   Foundations and Endowments
• Foundations are grant making institutions funded
  by gifts and investment assets
  – Must met certain annual spending limits to remain
    non-taxable depending on foundation type
• Endowments are long-term funds generally
  owned by operating non-profit institutions –
  universities, colleges, museums, hospitals.
  – They build up assets through gifts
  – Spending is determined by beneficiary institution,
    supplementing other revenue sources

             Types of Foundations
• Independent (private or family)
   – Makes grants to aid social, educational, charitable or religious
   – Funds provided by individual, group or family
   – Decision making authority lies with donor, family member or
     independent trustees
   – Must spend at least 5% of average assets plus expenses
• Company sponsored
   – Legally independent, but with close ties to corporation providing
   – Funds provided via endowment or annual contributions by a for-
     profit company
   – Decision-making authority lies with board of trustees, usually
     controlled by company executives
   – Must spend at least 5% of average assets
             Types of Foundations
• Operating Foundation
   – Uses resources to conduct research or provide service (such as
     running a museum)
   – Funds typically provided by individuals, groups or families
   – Decisions made by an independent board of trustees
   – Must use 85% of investment income in operational activity.
     Some also must spend at least 3.3% of average assets per year
• Community Foundation
   – Publicly supported organization making grants for social,
     educational, charitable or religious purposes (public charity)
   – Funds provided by the public, multiple donors
   – Decisions made by Board of Directors
   – Not subject to minimum annual spending requirement

   Foundations: Investment Objectives
            and Constraints
• Risk objective
    – High risk tolerance because maintaining spending level is more a desire than a
• Return objective
    – Preserve real value of assets while permitting desired or mandated spending
    – Intergenerational equity arises when spending rate can be sustained in real
      terms in perpetuity (i.e. mandated 5% spending rate + investment expenses +
      inflation rate = required return to assure intergenerational equity)
• Constraints
    –   Liquidity needed to provide for mandated spending levels
    –   Time horizon = perpetuity
    –   Tax concerns are minimal (unrelated business income, 2% excise tax)
    –   Legal and Regulatory – must comply with UMIFA or non-US equivalent
    –   Unique circumstances – many foundations have large holdings in a single

  Endowments: Investment Objectives
         and Constraints
• Risk objective
   – Must be consistent with goal of stable, real income over time
     (intergenerational equity)
   – Can be higher if institution can adapt to fluctuations by altering
   – If smoothing mechanisms are used, periods of high return can increase
     risk tolerance in subsequent periods
• Return objectives
   – High return needed to maximize sustainable real income
• Constraints
   –   Liquidity – sufficient to cover short-term spending needs
   –   Time horizon is long-term, with short term spending considerations
   –   Tax considerations are minimal
   –   Legal and Regulatory – UMIFA or equivalent, tax exempt status, etc.
   –   Unique circumstances – vary by endowment

 Life Insurance Companies: Investment
        Objectives and Constraints
• Risk objective
    – Significant future liabilities and sensitivity to interest rates reduce result in low
      risk tolerance
    – Many match assets with liabilities to the extent possible and have higher risk
      tolerance for “surplus” funds
• Return objective
    – Earn a positive spread over the rates paid to policyholders
• Constraints
    – Liquidity – usually not a concern, but rises with increased annuity payments
      and interest rate volatility
    – Time horizon – overall long-term, though often segmented to match product
    – Tax concerns – commercial entities subject to tax
    – Legal and regulatory factors – heavily regulated. Investments must be
      “eligible,” required to follow prudent investor rule, must maintain uniform
      valuation methods
    – Unique circumstances – Vary by insurer

    Non-Life Insurance Companies:
Investment Objectives and Constraints
• Risk objective
   – Ability to meet claims is paramount, and claims risk is
     unpredictable. Low risk tolerance.
• Return objective
   – Influenced by competitive pricing, profitability, surplus funds,
     tax considerations.
• Constraints
   – Liquidity needs – significant
   – Time horizon – short duration of liabilities interacts with more
     favorable returns for longer-duration assets
   – Tax concerns – complicated and typically requires complex
   – Legal and regulatory factors – fairly permissive with regard to

    Banks: Investment Objectives and
• Risk objective
   – Constrained by asset/liability management (ALM) – short-term
     deposits used to finance long-term loans
   – Below average risk tolerance
• Return objective
   – Positive spread over rate paid to depositors
• Constraints
   – Liquidity – significant need to cover deposit outflows and lending
   – Time horizon – intermediate, balancing the needs of return and
     managing interest rate risk
   – Tax concerns – fully taxable portfolios
   – Legal and regulatory – restrictions on stock and sub-investment grade
     bond investing

  Investment Companies, Commodity
        Pools and Hedge Funds
• Investment intermediaries whose sole
  corporate purpose is investing
• Each has specific investment objectives and
  constraints, legally outlined in a prospectus or
  other document
• No general investment objectives and
  constraints are applicable to all investment


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