CFA 2018 r13 managing institutional investor portfolios

Level III Managing Institutional Investor Portfolios www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents and Introduction Introduction Pension Funds Foundations and Endowments The Insurance Industry Banks and Other Institutional Investors www.ift.world Excerpt from CFA Level I reading on Basics of Portfolio Management (2011-12) www.ift.world Pension Funds Plan Sponsor Defined Contribution Plan Defined Benefit Plan Sponsor directed vs participant directed Pension liability Sponsor bears investment risk No financial liability for plan sponsor Participants bear early termination risk Plan participants bear investment risk Contributions and returns belong legally to participant Retirement assets are portable www.ift.world 2.1 Defined-Benefit Plans: Background and Investment Setting Funded Status: Fully Funded (Pension Surplus) Underfunded Plan Accumulated Benefit Obligation (ABO): PV of pension benefits if plan stops today Projected Future Obligation (PBO): Like ABO but projects future compensation increase Total Future Liability: PV of accumulated and projected future compensation increases Total Liability = Labiality from Retired Lives + Liability from Active Lives Ratio impacts liquidity requirement and duration www.ift.world DB Plan Risk Objectives Exhibit 1: Factors impacting risk tolerance and risk objectives of DB plans www.ift.world Example – Apex Sports Equipment Corporation (ASEC) Risk Tolerance www.ift.world Asset Liability Management (ALM) focuses on risks created by interaction of assets and liabilities Plan Assets vs PBO Shortfall Risk: portfolio might fall below some threshold level over a given horizon Minimize probability that assets will fall below a certain level For DB Plan consider shortfall risk of funded status See bullet points before Example Example – ASEC Risk Objective Top priority: maintain funded status (Plan Assets/PBO) > 100% What is an appropriate risk objective? www.ift.world Return Objectives Should be consistent with risk objective Specify numerical return objectives Achieve returns that adequately fund pension liability on an inflation-adjusted basis Use discount rate for future obligations as a starting point Discount future obligations and at long-term government bond rate Might have an objective to minimize pension contributions Might have an objective related to pension income www.ift.world www.ift.world 10 Life Insurance Companies – Constraints Tax Concerns Unlike pension funds, foundations and endowments, life insurance companies pay taxes Focus on after-tax return Policyholders’ share; used to meet credited rates Not taxed! Investment Income Corporate share; transferred to surplus Taxed www.ift.world 31 Life Insurance Companies – Constraints Legal and Regulatory Factors Heavily regulated in the U.S Eligible investments Prudent investor rule Valuation methods Unique Circumstances Depends… Example 14 www.ift.world 32 4.2 Non-Life Insurance Companies Broad category which includes: health, property, liability, auto insurance; investment policy similar across non-life insurance companies Relative to life insurance, non-life insurance: Liability durations are shorter Claims processing longer Lower interest rate risk (some inflation risk) Liabilities uncertain in time and value Long tail Underwriting (profitability) cycle www.ift.world 33 Non-Life Insurance Companies – Risk Objectives Ability to meet policyholder’s claims is the dominant consideration Often need to replace damaged assets  inflation risk Consider cash flow characteristics: timing and amount uncertain Premium to surplus ratio between 2-to-1 and 3-to-1 Common stock between ẵ or ắ of total surplus Overall risk tolerance: Low www.ift.world 34 Non-Life Insurance Companies – Return Objectives Factors to consider:  Competitive pricing  Profitability  Growth of surplus  After-tax total returns Return objectives (adapted from Example 15) Earn sufficient return to fund policyholder liabilities Support competitive pricing of all products Contribute to growth of surplus through capital appreciation www.ift.world 35 Non-Life Insurance Companies – Constraints Liquidity Requirements Liquidity requirement is generally high  hence need high portion of liquid assets in portfolio Example 15: The portfolio will be managed to meet the liquidity requirements to pay all benefits and expenses in a timely manner Investment cash flows will be a primary source of liquidity to minimize lower yielding cash reserves Publicly traded securities will provide an additional source of liquidity Time Horizon Depends on duration of liabilities Generally time horizon is long term Mix of taxable and tax-exempt bonds Equities www.ift.world 36 Non-Life Insurance Companies – Constraints Tax Tax considerations determine the optimal allocation of taxable and tax-exempt bonds Tax considerations play a role in realization of gains and losses for bond and stock portfolios Legal and Regulatory Factors All investments must qualify under insurance law of the state in which Company is domiciled Unique Circumstances Example 15: private placement bonds are not authorized Example 15 www.ift.world 37 5.1 Banks Liabilities primarily consists of time deposits and demand deposits Financial assets: loan portfolio and investment portfolio ALM challenge Exhibit www.ift.world 38 Net interest margin Interest spread Leverage-adjusted duration gap www.ift.world 39 Objectives in managing securities portfolios: www.ift.world 40 Example 16 IPS for Commercial Bank Risk objective dominated by ALM considerations Consider risk relative to liabilities rather than absolute risk www.ift.world 41 5.2 Other Institutional Investors Investment Companies Open-end mutual funds, closed-end mutual funds, exchange traded funds Invest in equity and fixed income Risk, return objectives and constraints vary Commodity Pools Give investors exposure to commodities through commodity futures contracts Risk, return objectives and constraints vary Hedge Funds Also a pooled investment vehicle Cater to high net worth individuals Strategies and underlying assets vary Risk, return objectives and constraints vary www.ift.world 42 Summary Investment Objectives and Constraints across Institutions Risk Tolerance Return Liquidity Time Horizon DB Plan (Ex – 7) High Funding adequacy Benefit payments Typically long term Foundation (Example 12) High Preserve value Met expenses (5%) Met expenses Typically long term Endowment (Example 13) Generally high but depends on a few factors Based on spending targets Meet spending targets Typically long term Life Insurance (Example 14) Low (valuation concerns, reinvestment risk, credit risk, cash flow) Fund liabilities Pay benefits and expenses in timely manner Typically long term Non-Life Insurance (Example 15) Low (high cash flow volatility) Fund liabilities; support competitive pricing High Typically long term Bank Low Positive spread High Short term www.ift.world 44 Concluding Remarks • Factors which drive investment policy • Asset Liability Management Considerations – Pension Funds, Insurance Companies, Banks • IPS for different types of institutions – almost a guaranteed question • “Learn” IPS examples, return and spending rate calculations • Practice problems www.ift.world 45 ... Funds Foundations and Endowments The Insurance Industry Banks and Other Institutional Investors www.ift.world Excerpt from CFA Level I reading on Basics of Portfolio Management (2011-12) www.ift.world