CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz smart summary, study session 6, reading 13

2018 Study Session # 6, Reading # 13 “MANAGING, INSTITUTIONAL INVESTOR PORTFOLIOS” IR = Interest Rates FI = Fixed Income ALM = Asset Liability Management FS = Funded Status DB = Defined Benefit DC = Defined Contribution PBO = Projected Benefit Obligation ABO = Accumulated Benefit Obligation PENSION FUNDS Types of Pension Plans DB Plan DC Plan Plan sponsor’s obligation in terms of the benefit to plan participants Investment risk is borne by plan sponsor Early termination risk Hybrid Plans Sponsor’s obligation is to contribute to the pension fund Participants bear the investment risk Can be sponsor directed or participant directed Cash balance plan ⇒ DB plan whose benefits are displayed in individual record keeping accounts 2.1 Defined-Benefit Plans: Background and Investment Setting Pension plan’s performance should be judged relative to the adequacy of its assets with respect to funding pension liabilities If plan’s assets are > ሺ than needed to maintain purchasing power is acceptable 3.1.2 Return Objectives Foundations vary in their return objectives because: Some are short term while others are long term in their nature Minimum return requirement should cover the spending needs, inflation & management expenses 3.1.3 Liquidity Requirements Anticipated or unanticipated cash needed in excess of contributions made to the foundation Smoothing rule is used to avoid large fluctuations in operating budget Anticipated needs are captured by the spending rate Cash reserve for contingencies by some private foundations 3.1.4 Time Horizon Usually longer time horizon Greater ability to bear risk 3.1.5 Tax Concerns Not-for-charitable purposes income is taxed at regular corporate tax rates Private foundation pays a 2% tax on its net investment (may reduced to 1%) Copyright © FinQuiz.com All rights reserved 2018 Study Session # 6, Reading # 13 3.1.6 Legal and Regulatory Factors Variety of legal & regulatory constraints (vary by country & sometimes by type of foundation) 3.1.7 Unique Circumstances Single stock position restricted by the donor from diversifying 3.2 Endowments: Background and Investment Setting Fund established to provide budgetary support for universities, colleges, hospitals etc Not subject to legally required spending level Spending Rule Simple Spending Rule Rolling Three-Year Average ܵ‫݃݊݅݀݊݁݌‬௧ = ܵ‫ܸܯ ݃݊݅݀݊ܧ × ݁ݐܽݎ ݃݊݅݀݊݁݌‬௧ିଵ ܵ‫݃݊݅݀݊݁݌‬௧ = ܵ‫ × ݁ݐܽݎ ݃݊݅݀݊݁݌‬ሺ1⁄3ሻ[‫ܸܯ ݃݊݅݀݊ܧ‬௧ିଵ + ‫ܸܯ ݃݊݅݀݊ܧ‬௧ିଶ + ‫ܸܯ ݃݊݅݀݊ܧ‬௧ିଷ ] Problem ⇒ place equal weights to all three years Geometric Smoothing Rule ܵ‫݃݊݅݀݊݁݌‬௧ = ‫ݐ݋݋݉ݏ‬ℎ݅݊݃ ‫ × ݁ݐܽݎ‬ൣ‫ ݃݊݅݀݊݁݌ݏ‬ሺ௧ିଵሻ × ሺ1 + ݂݈݅݊ܽ‫݊݋݅ݐ‬௧ିଵ ሻ൧ + ሺ1 − ‫ݐ݋݋݉ݏ‬ℎ݅݊݃ ‫݁ݐܽݎ‬ሻሺ‫ܸܯ ݃݁ܤ × ݁ݐܽݎ ݃݊݅݀݊݁݌ݏ‬௧ିଵ ሻ Place more emphasis on recent MV & less on past values 3.2.1 Risk Objectives Depends on the endowment’s role in the operating budget & institution’s ability to in spending: Lower the need for endowment contribution, the risk tolerance the correlation b/w donor’s base & endowment, the risk tolerance Large fixed expenditures can reduce risk tolerance 3.2.2 Return Objectives Sum of spending rate, the expected inflation rate & management fee can serve as starting points for appropriate return objective The relevant inflation rate may differ from that of the general economy Long-term average spending rate must be < than the long term expected real return to preserve purchasing power Copyright © FinQuiz.com All rights reserved 2018 Study Session # 6, Reading # 13 3.2.3 Liquidity Requirements Perpetual nature & measured spending of true endowments limit their need for liquidity Cash needs (to make spending distributions, to meet capital commitments & to facilitate portfolio rebalancing transactions) 3.2.4 Time Horizon Long term & multistage (in some cases) 3.2.5 Tax Concerns Not a major concern (usually tax exempt) 3.2.6 Legal and & regulatory Factors UMIFA is the primary governing legislation for endowments in U.S 3.2.7 Unique Circumstances Socially responsible investing may become constraints (e.g child labor, gambling etc.) THE INSURANCE INDUSTRY Insurance industry has two broad categories: Life insurance Casualty insurance Insurance companies are established either stock companies or mutual 4.1 life Insurance Companies: Background and Investment Setting Duration management is a major concern in investment setting Risk of disintermediation becomes acute when IR are high: One type of disintermediation occurs when policyholders borrow against cash value in insurance at below market policy loan rates Other type ⇒ policyholders surrender their cash value of insurance to reinvest at higher rates Some new insurance products are: Universal life ⇒ provides premium flexibility & adjustable death benefits Unit-linked life insurance: Type of ordinary life insurance Death benefits & cash values are linked to investment performance Variable universal life ⇒ combines features of above two Copyright © FinQuiz.com All rights reserved 2018 Study Session # 6, Reading # 13 4.1.1 Risk Objectives Primary investment objective ⇒ to fund future policyholders’ benefits & claims Insurance regulators have been moving towards risk-based capital to ensure adequate surplus ALM approach is useful to control IR risk & liquidity for a life insurance company Aspects of IR risk Valuation concerns Reinvestment risk Credit risk & CF volatility are other risk objectives 4.1.2 Return Objectives Specified primarily by the rates that actuaries use to determine policyholder reserves (minimum return requirement) Desired net interest spread ⇒ diff b/w interest earned & interest credited to policyholders Surplus growth is another return objective Segmentation has promoted sub-portfolio return objectives 4.1.3 Liquidity Requirements A major concern in periods of sharply rising IR In assessing liquidity needs, insurers must address the following Disintermediation Asset marketability risk 4.1.4 Time Horizon Traditionally, life insurance companies were considered long term investors ALM has tended to shorten the time horizon 4.1.5 Tax Concerns Insurance companies are taxable investors so focus should be on after tax returns Income can be viewed into two parts for tax purposes: Portion related to the rate necessary to fund reserve is not taxed Surplus is taxed 4.1.6 Legal and Regulatory Factors Important concepts related to regulatory concerns include: Eligible investments Prudent investor rule Valuation methods 4.1.7 Unique Circumstances Company’s size & the sufficiency of its surplus position are among the considerations influencing portfolio policy Copyright © FinQuiz.com All rights reserved 2018 Study Session # 6, Reading # 13 4.2 Non-Life Insurance Companies: Background and Investment Setting These include health, property, liability, marine, surety insurance Investment policies differ significantly from life insurance Characteristics of non-life insurance industry: Cyclical in nature Long tail nature of liabilities Underwriting cycle Business cycle 4.2.1 Risk Objectives Ability to meet policyholder’s claims is a dominant consideration Inflation must be considered due to replacement cost or current cost coverage The ratio of premium income to total surplus should be maintained b/w +2 to to to Volatile stock market conditions lower the % of surplus invested in equities 4.2.2 Return Objectives Factors influencing return objective include: Competitive policy pricing ⇒ low premium rates, desired return objectives Profitability ⇒ investment income & the portfolio returns are primary determinants Growth of surplus ⇒ provides opportunity to expand the volume of insurance Tax considerations ⇒ flexibility to shift b/w taxable & tax exempt bonds Total return management 4.2.3 Liquidity Requirements Important consideration due to uncertainty of the CF Casualty Company needs to manage the marketability schedule 4.2.4 Time Horizon Duration of causality liabilities are typically than life insurance liabilities Under writing cycle affect the mix of taxable & tax exempt bond holdings Long-term equity investor status has been modified due to turnover in stocks portfolio 4.2.5 Tax Concerns Tax is an important consideration: Asset allocation b/w taxable& tax exempt bonds Subject to tax code modification Copyright © FinQuiz.com All rights reserved 2018 Study Session # 6, Reading # 13 4.2.6 Legal and Regulatory Factors No asset valuation reserve requirement Subject to risk-based capital requirement Eligible asset classes & quality standard for each class are subject to regulations 4.2.7 Determination of Portfolio Policies In determining investment policy, limited investment risk tolerance & difficulty in forecasting CF are important considerations BANKS AND OTHERINSTITUTIONAL INVESTORS 5.1 Banks: Background and Investment Setting Portfolio of investment securities ⇒ residual use of funds after loan demand has been met Play a key role in managing bank’s risk & liquidity positions Profitability measures: Net interest margin ⇒ net interest income/average earning assets Interest spread ⇒ interest yield –interest cost of liabilities Risk measures: Leverage-adjusted duration gap ⇒‫ܦ‬஺ − ሺ‫ܦ × ܭ‬௅ ሻ where ‫ܦ‬஺ = duration of assets ‫ܦ‬௅ = duration of liabilities ‫ݏ݁݅ݐ݈ܾ݈݅݅ܽ݅ ݂݋ ܸܯ‬ ‫ = ܭ‬ ‫ݏݐ݁ݏݏܽ ݂݋ ܸܯ‬ For a +ve (-ve) IR shock: the MV of net worth ( ) for a bank with +ve (-ve) gap Value at risk ⇒minimum value of losses expected over a specified time period at a given level of probability Securities Portfolio’s Objectives Adjustment mechanism for IR risk To assure adequate liquidity To produce income To modify & diversify overall credit risk To meet other needs e.g pledging requirement Portfolio’s Objectives 5.1.1 Risk Objectives 5.1.2 Return Objectives ALM considerations Below-avg risk tolerance +ve return on invested capital Positive spread over the cost of funds Copyright © FinQuiz.com All rights reserved 2018 Study Session # 6, Reading # 13 Portfolio’s Constraints 5.1.3 Liquidity Requirements 5.1.4 Time Horizon Determined by: Net outflow of deposits Demand for loans Liability structure reflects an overall shorter maturity than its loan portfolio Time horizon is usually intermediate term 5.1.5 Tax Concerns 5.1.6 Legal & Regulatory Factors Fully taxable Restrictions on bankholding of common shares & below investment grade bonds Risk based capital regulations 5.1.7 Unique Circumstances Factors such as loan concentration & community needs are important considerations 5.2 Other Institutional Investors: Investment Intermediaries Investment companies serve as financial intermediate Pooled investor funds usually invested in equity & F.I markets Commodity pools ⇒ invest in futures rather than equity & F.I markets Hedge funds ⇒ market to other institutional investors & high net-worth individuals & subject to fewer regulations Non-financial corporation⇒ major investor in money markets Copyright © FinQuiz.com All rights reserved  ... expected real return to preserve purchasing power Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 6, Reading # 13 3 .2 .3 Liquidity Requirements Perpetual nature & measured spending... rates Private foundation pays a 2% tax on its net investment (may reduced to 1%) Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 6, Reading # 13 3.1.6 Legal and Regulatory Factors... the considerations influencing portfolio policy Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 6, Reading # 13 4 .2 Non-Life Insurance Companies: Background and Investment Setting