Institutional Portfolio Management

• Investment Strategies
• Defined Benefit Plans
  • DB Plan Calculation
• Foundations and Endowments
  • Example IPS
  • Yale Formula
  • Investment Approaches
    • Norway Model
    • Endowment Model
    • Canada Model
    • LDI Model
• Insurance
• Banks
• Hedge Fund Strategies
  • Equity Market Neutral Strategies
  • Volatility Strategies
• Mutual Fund
• Alternative Assets Allocation
  • Traditional approaches
  • Risk-based approaches
• FOF vs. Multi-strategies
• Alternative Investment Risks

Investment Strategies

• Index: Passive
• Tactical: allows short term deviations from target portfolio weight
• Dynamic: allows long term deviations from target portfolio weight

Defined Benefit Plans

• Return: The actuarial discount rate or somewhat higher.
• Risk: Determined by plan and sponsor characteristics. Factors reducing risk tolerance include shorter time horizon, higher liquidity needs, weak sponsor, and positive correlation of sponsor results with plan asset returns.
• Time horizon: Linked to liability duration.
• Taxes: Generally untaxed.
• Legal/regulatory: A prudent expert managing the assets for the benefit of plan participants.
• Liquidity: Linked to needs for plan payouts.
• Unique: Watch for small plans with inadequate resources to complete proper due diligence.

DB Plan Calculation

• The maximum discount rate allowed for pension plan is the high-grade bond yields averaged over the last 25 years
• The required return for the plan asset should exceed the discount rate on plan liabilities.
• US GAAP requires firms to report the value of the overfunded or underfunded pension plan on the balance sheet as an asset or a liability, respectively.

Foundations and Endowments

• Return: Geometric link of distribution, relevant inflation, and expense rates.
• Risk: Often higher, may be diminished if the beneficiary is heavily dependent on the distributions.
• Time horizon: Often perpetual.
• Taxes: Generally untaxed, but watch out for specifically taxed income sources.
• Legal/regulatory: Relatively unregulated.
• Liquidity: Situation specific.
• Unique: Watch for concentrated positions, restrictions on sale, and SRI.

Example IPS

The mission of xx University Endowment is to provide scholarships for students attending the university.

In order to achieve this mission, the Endowment must maintain the purchasing power of the assets in perpetuity while achieving investment returns sufficient to sustain the level of spending necessary to support the scholarship budget.

Therefore, the investment objective of the endowment should be to achieve a total real rate of return (after inflation) of at least 6% with a reasonable level of risk.

Yale Formula

Spending for current fiscal year = (60% × Spending for previous fiscal year) + 40% × (5% × Endowment market value at the end of previous fiscal year).

• Consistent with an investment objective of achieving long-term returns that support the spending rate while preserving the value of the endowment in real terms over time
• Intended to bring about a predictable pattern of distributions for better planning of resource deployment
• Incorporates a smoothing, countercyclical element. This leads to lower spending rates in a period of sustained strong investment returns but higher spending rates in a protracted weak return environment.

Investment Approaches

Norway Model

• Traditional style characterized by 60%/40% equity/fixed-income allocation, few alternatives, largely passive investments, tight tracking error limits, and benchmark as a starting position.
• Pros: Low cost, transparent, suitable for large scale, easy for board to understand, low management risk
• Cons: Limited value-added potential.

Endowment Model

• Characterized by high alternatives exposure, active management and outsourcing.
• Pros: High value-added potential.
• Cons: Expensive and difficult to implement for most sovereign wealth funds because of their asset sizes; higher costs/fees

Canada Model

• Characterized by high alternatives exposure, active management, and insourcing.
• Pros: High value-added potential and development of internal capabilities.
• Cons: Potentially expensive and difficult to manage.

LDI Model

• Characterized by focus on hedging liabilities and interest rate risk including via duration-matched, fixed-income exposure. A growth component in the return-generating portfolio is also typical (exceptions being bank and insurance company portfolios).
• Pros: Explicit recognition of liabilities as part of the investment process.
• Cons: Certain risks (e.g., longevity risk, inflation risk) may not be hedged.

Insurance

• Return: At minimum the return assumed by the actuaries, may be set by line of business.
• Risk: Generally conservative though the surplus may be invested more aggressively.
• Time horizon: Related to duration of the liabilities, non-life tends to be shorter but with a long tail related to claims litigation.
• Taxes: Generally taxable.
• Legal/regulatory: Heavily regulated at multiple levels. Non-life is generally less regulated.
• Liquidity: Situation specific. Life is generally more predictable than non-life. Some life policies introduce disintermediation risk. Non-life may also insure replacement value making liquidity needs dependent on inflation.
• Unique: None in particular.

Banks

• Return: Contribute to interest earnings, but the securities portfolio is primarily a residual used to manage overall asset duration and provide liquidity.
• Risk: Heavily regulated and conservative.
• Time horizon: Related to duration of the liabilities, generally shorter.
• Taxes: Generally taxable.
• Legal/regulatory: Heavily regulated at multiple levels. Subject to numerous asset and capital limits.
• Liquidity: Emphasis on highly liquid securities, mainly government securities.
• Unique: None in particular.

Modified Duration of Equity = (A/E) * Asset Duration - (A/E - 1) * Liability Duration * (Δi/Δy)

Change in equity capitalization value = Δy * - modified duration

Variance of change in equity capitalization value = (A/E)^2 * asset variance + (A/E - 1) * liability variance - 2 * (A/E) 8 (A/E - 1) * Asset SD * Liability SD * Correlation

Hedge Fund Strategies

Equity Market Neutral Strategies

• Take opposite (long and short) positions in similar or related equities having divergent valuations while attempting to maintain a near net zero portfolio exposure to the market.
• Typically utilize leverage
• Typically deliver return profiles that lower but less volatile than those of many other hedge strategy areas.
• More useful for portfolio allocation during periods of non-trending or declining markets

Volatility Strategies

• Through simple exchange-traded options: The maturity of such options typically extends to no more than two years. The longer-dated options will have more absolute exposure to volatility levels than shorter-dated options, but the shorter-dated options will exhibit more delta sensitivity to price changes.
• Through OTC options: The tenor and strike prices of the options can be customized and be extended beyond what is available with exchange-traded options.
• Through use VIX futures or options on VIX futures: can more explicitly express a pure volatility view without the need for constant delta hedging of an equity put or call for isolating the volatility exposure.
• Through an OTC volatility swap or a variance swap: A volatility swap is a forward contract on future realized price volatility. Both swaps provide “pure” exposure to volatility alone

Mutual Fund

• Open-end fund tends to be less liquid than close-end fund

Alternative Assets Allocation

Traditional approaches

Pros:

• Easy to communicate. Listing the roles of various asset classes is intuitive and easy to explain to the decision makers, who often have familiarity with the traditional asset class-based approach.
• Relevance for liquidity management and operational considerations. The traditional categorization of asset classes may make it easier to identify relevant mandates for the portfolio’s alternative investments.

Cons:

• Over-estimation of portfolio diversification.
• Obscured primary drivers of risk.

Risk-based approaches

Pros:

• Common risk factor identification. Investors are able to identify common risk factors across all investments, whether public or private, passive or active.
• Integrated risk framework. Investors are able to build an integrated risk management framework, leading to more reliable portfolio-level risk quantification.

Cons

• Sensitivity to the historical look-back period.
• Implementation hurdles.
• Determining which risk factors should be used and how to measure them in different asset classes. One drawback with risk-based approaches is the decision on which risk factors to use is somewhat subjective and how these factors are measured can also be subjective.

FOF vs. Multi-strategies

• Multi-strategy managers can reallocate capital into different strategy areas more quickly and efficiently than would be possible by a fund-of-funds (FoF) manager.
• The multi-strategy manager has full transparency and a better picture of the interactions of the different teams’ portfolio risks than would ever be possible for FoF managers to achieve.
• FoF investors always face netting risk, whereby they are responsible for paying performance fees due to winning underlying funds while suffering return drag from the performance of losing underlying funds.
• FoF has multiple layers of fees.

Alternative Investment Risks

• Key person risk
• Alignment of interests
• Style drift: Investors should understand where the fund manager has a competitive advantage and skill and confirm that the investments are consistent with the manager’s advantage.
• Risk management
• Client/asset turnover
• Client profile: Investors should confirm that the other clients are long-term investors and that they have similar investment goals and desired outcomes.
• Service providers: Investors should ensure that the fund manager has engaged independent and reputable third-party service providers, including administrators, custodians and auditors.