Institutional Investors

How do you calculate the variance in equity for a bank?

(A/E)^2 x variance of asset returns + (A/E-1)^2 x variance of liability returns - 2(A/E)(A/E-1)(correlation between asset and liability returns)

What are the four main institutional investor models?

-Norway model -Endowment model -Canada model -LDI model

Describe the Norway model characteristics in terms of: -public/private securities -typical allocation -tracking error -advantages -disadvantages

-Typically public -60/40 allocation -tight tracking error -low cost, little complexity for the board, investments are transparent -limited potential for value add/alpha

Who are the stakeholders in a SWF? (4)

-country residents (current and future) -governments -external asset managers -SWF management

What are the characteristics of the LDI model in terms of -objective -allocation -pros -cons

-generate returns to cover liabilities -mostly to fixed income, but can include a hedging portfolio in fixed income and a return portfolio which includes equities -recognition of liabilities as part of the investment process -unhedged risks such as inflation

Describe the Endowment model characteristics in terms of: -public/private/alt securities -typical allocation -advantages -disadvantages

-high allocation to alts -high allocation to alts -Great for universities with low liquidity needs, long time horizon, and access to good AI management -High costs, only available to institutions with size and scale

For both life and PC insurers, what are the two parts of their liquidity system?

-investment portfolio/cash, cash from operations -long term debt (bonds)

Describe the following for savings funds: -liabilities - long or short term? -liquidity needs -Risk tolerance - high or low? -asset allocation -investment objective

-long term -low liquidity needs -high risk tolerance -due to long horizon can invest in equities and alts -capital preservation and grow wealth for future generations

In terms of managing A/L, what are a bank's and regulators goals?

-minimize asset/liability duration mismatch -minimize equity volatility

Describe the following for reserve funds: -objective for returns -what do liabilities consist of? -typical asset allocation -liquidity needs

-objective is to get higher rate of return than that on monetary stabilization bonds -liabilities consist of stabilization bonds -Can invest in higher yielding assets to get a high enough return like equities and alts but not as much alts as savings funds -middle of the pack liquidity - less than stabilization but more than savings, use public equities

What are two ways a sponsor can remove pension driven BS volatility?

-offering lump sum payments to beneficiaries to leave pension program -negotiate a transfer of risk to another provider

What are the two main objectives of a pension fund?

-provide adequate return to meet liabilities with specified risk -minimize the PV of expected cash contributions

Describe the following for budget stabilization funds: -liabilities - certain or uncertain? -main objective (income or capital preserve, return objective) -liquidity needs -typical asset allocation

-uncertain -capital preservation and returns in excess of inflation -high need for liquidity -cash or investment grade fixed income

Describe the following for development funds: -liabilities - certain or uncertain? -liquidity needs -return objective

-uncertain liabilities -liquidity needs can vary with the length of the project -Return objective above country's GDP

What are the five common characteristics of institutional investors?

1. Asset size (how does large size impact costs, etc) 2. long inv horizon 3. regulated 4. governance is more complex than private clients 5. Principal Agent issues

In the IPS of institutional investors, what should be included about returns?

A return objective above inflation that covers required return

What are the typical investment objectives for a DB pension fund? (1)_

Be overfunded

Why can't banks just lend long and borrow short?

Because a duration mismatch means that for small changes in interest rates, the value of assets and liabilities would change such that the bank's equity would become volatile

Do institutional investors typically have high or low liquidity needs?

Low liquidity needs

Do defined contribution plans have higher or lower financial risk for plan sponsors?

Lower since employees bear the brunt of the investment risk

What is another way the Norway model allocates investments other than 60/40?

Can use factor exposures

Does the sponsor of a DB plan prefer to use a higher or lower discount rate? What about the beneficiaries?

Company wants to use a higher discount rate to make the PV of the liability smaller. Beneficiaries want a lower discount rate because it makes the PV of the liability higher

Generally, do PC insurers need highly liquid assets or less liquid?

Highly liquid, they have a short investment horizon relative to life insurers

What are the typical investment objectives for a bank/insurance company? (1)

Maximize NPV by managing assets and liabilities

What is the equation to calculate the modified duration of a bank's equity capital? How is delta i / delta y defined? How is equity to capital ratio defined in problems?

Duration of Equity = (A/E) Duration of Assets - (A/E - 1) x Duration of Liabilities x (delta i ./ delta y) Delta i / Delta y is defined by change in liabilities yield for a change in asset yield in bps /100. Equity capital ratios are ratios of Equity to Assets

What is typically the difference in skill between endowment managers and foundation managers?

Endowment managers tend to be more skilled

What type of economies tend to have reserve funds?

Export economies with large FX reserves

What is a limited life foundation?

Foundation that has to spend down assets

What is an insurers goal (IPS)?

Full and timely payout of claims

What are the three types of accounting banks are subject to?

GAAP Statutory accounting used by regulators which doesn't include intangibles and results in lower earnings True economic accounting which marks to market and is the most volatile but best picture of economic well being

How are university endowments typically funded?

Gifts from alumni

Do commercial banks have higher/lower cost of funds and lower/higher liquidity than retail banks

Higher cost and less liquid

Do foundations have higher or lower liquidity needs compared to university endowments? Why?

Higher liquidity needs given requirement to pay out 5% of assets to maintain tax free status but still relatively low

Regarding mortality risk, what's a plus for DB plans?

If a plan employee dies early, then their unused benefit is used to benefit participants that live longer

How would a DB plan funded status impact its liquidity?

If a plan is well funded, the employer may reduce contributions, so there will be a greater need to hold higher balances of liquid assets

How do pensions play into managing a workforce?

If lots of employees are vested, it can make it harder to reduce headcount

When would an employer be more willing to take on risk in a pension portfolio vs willing to take on less risk?

If the plan's assets/liabilities are small relative to the company balance sheet, then there may be more flexibility to take on more risk. If they are large, there may be less appetite for risk

For a pension reserve fund, what are the accumulation phase and decumulation phase

In the accumulation phase, the government contributes more and in the decumulation phase, the government withdraws from the fund

How does the risk tolerance in an IPS differ between an individual client and an institutional investor? How can risk tolerance be expressed for a DB pension fund? For a bank?

Institutional investors have more varied ways of showing risk tolerance such as surplus vol (vol of assets - vol of liabilities) for pension plans, VaR, conditional VaR for banks

What is the investment horizon for a university endowment?

Investment horizon is perpetuity

what is a university endowment spending policy?

It details the university's stream of payments to make sure that there is intergenerational equity and to smooth endowment payouts

What happens to the pension obligation if investment return expectations increase?

It might result in a higher discount rate being used and a lower obligation

How would the mix of retirees to non-retirees impact liquidity and risk tolerance?

More retirees: Need to be more liquid and less risky Fewer retirees: Less need to liquidity and more risky

Would a large allocation to fixed income be appropriate for an investor with a long investment horizon and low liquidity needs?

No

What is a "mature" DB plan?

One with a lot of retirees. It will have high need for liquidity and less risk tolerance.

For life insurers what's the difference between the general and separate account?

The general account is used for products where the company bears the investment risk and the separate account is used for variable products where the investment risk is borne by the customer The general account has a reserve account to meet the liability and a surplus account to boost returns

What is the relationship between a bank's equity and assets?

Small changes in the value of assets leads to outsized changes in bank equity

Are banks considered institutional investors?

Technically yes

What is a common source of tension in university endowments and foundations?

Tension can exist between current grant spending vs preserving sufficient funds to serve future generations of grant recipients

What happens to the volatility of a bank's equity as the correlation of asset and liability moves move to 1?

The volatility decreases to 1

What is the purpose of a savings sovereign wealth fund?

They are created to convert nonrenewable resources into financial assets for future generations

What is the typical tax situation for sovereign wealth funds?

They are typically free of taxes

What is the purpose of pension reserve sovereign wealth funds?

They are used to meet pension obligations

How does the Canada Model compare to the Endowment model in terms of: -allocation to alts -external/internal management -use of a reference portfolio/total portfolio

They both have a high allocation to alts but the Canada Model relies more on internal management and relies on a reference portfolio which is a standard portfolio with public securities and a total portfolio which includes alts for added return

What special requirement do foundations have?

They have to payout a certain amount each year of their asset value to stay tax free

What is the purpose of a budget stabilization sovereign wealth fund?

They isolate a country from commodity price vol and shocks

What is the purpose of reserve sovereign wealth funds?

They reduce the negative cost of carry on reserves or earn a higher return on reserves

What are the main goals of university endowments? (2) What are the investment objectives of university endowments? (1)

To support the operating budget to provide intergenerational equity -to preserve and grow value of perpetuity capital at some percent return and with reasonable risk

Suppose a DB plan sponsor has a cyclical core business. How should the plan assets be correlated/uncorrelated with the core business?

Uncorrelated so the plan's funded status doesn't deteriorate in a downturn

Are the investment professionals of an endowment or foundation generally more skilled?

University endowment

Do foundations and endowments tend to be tax free?

Yes

Do smaller institutional clients find it harder to access private equity and real estate?

Yes

Does the plan sponsor in a defined contribution plan still have a fiduciary responsibility?

Yes

Do pension reserve funds invest in alts?

Yes due to long time horizon

Does the endowment model rely on passive or active management?

active

What is the purpose of a development sovereign wealth fund?

allocate resources to priority socioeconomic projects and infrastructure

What are the three types of endowment spending policies?

constant growth rule - endowment provides university with a fixed amount each year tied to inflation (the HEPI index) market value rule - endowment provides a percentage of asset value each year (pro cyclical, spend more in up years, less in down years) hybrid rule - spending is calculated as a weighted average of the constant growth rule and market value rule

For the endowment model, are investments typically managed in house or externally?

high degree of external management

The higher/lower a bank is levered, more more/less pronounced the beneficial effect of a higher correlation between assets and liabilities

higher, more

How can a bank shorten the duration of its assets and extend duration of its liabilities?

issuance of long term debt and investing in floating rate securities on the asset side. Also holding cash which is a low duration asset

What would the effect on the pension obligation be if employee turnover goes down?

more employees will vest, increasing the pension obligation

What is the main investment objective of a defined contribution plan? (2)

to grow assets prudently to support retirement spending needs there is also a desire to outperform other DC plans

What is the Yale spending rule?

w x [Spending Amount in Year t x (1+Inflation Rate)] + (1-w) x Spending Rate x Average AUM

What is disintermediation risk?

when whole life insurance policyholders surrender or borrow accumulated cash values and deposit them in higher yielding securities