CFA level 3 study notebook2 2015

StudySession 6 Cross-Reference to CFA Institute Assigned Reading#14-Managing Institutional Investor PortfoliosLOSl4.j:Discussthefactors that determineinvestmentpolicy for pension funds,

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BOOK 2 - INSTITUTIONAL INVESTORS,

StudySession6-Portfolio Management for InstitutionalInvestors 8

Self-Test-Portfolio Management for InstitutionalInvestors 60

StudySession 7 -Applications ofEconomicAnalysistoPortfolio Management 63

StudySession 8 -AssetAllocation and RelatedDecisions

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SCHWESERNOTES™ 2015 CFALEVEL IIIBOOK2:INSTITUTIONAL

Publishedin2014 by Kaplan,Inc

Printedinthe UnitedStatesofAmerica

ISBN:978-1-4754-2784-4/1-4754-2784-0

PPN:3200-5563

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was

distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation

of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy

or quality of the products or services offered by Kaplan Schweser.CFA®and Chartered Financial

Analyst®are trademarks owned by CFA Institute.”

Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute Reproduced and republished from 2015 Learning Outcome Statements, Level I, II, and III questions fromCFA®

These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.

Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth

by CFA Institute in their 2015 CFA Level III Study Guide The information contained in these Notes

covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.

However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes.

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READINGS AND

READINGSThefollowing materialisa reviewofthe InstitutionalInvestors,Capital Market

Expectations,EconomicConcepts, andAsset Allocation principles designedtoaddress the

learningoutcome statements setforthbyCFA Institute

ReadingAssignments

PortfolioManagementforInstitutionalInvestors,CFA Program 2015Curriculum,

Volume2,LevelIII

14.Managing Institutional Investor Portfolios

15 LinkingPensionLiabilitiestoAssets

page8page52

STUDY SESSION 7

ReadingAssignments

ApplicationsofEconomicAnalysistoPortfolioManagement,CFAProgram 2015

Curriculum,Volume3,Level III

16.Capital Market Expectations

17 Equity Market Valuation

page63page 119

ReadingAssignments

AssetAllocation and RelatedDecisions inPortfolioManagement(1),CFA Program 2015

ReadingAssignments

AssetAllocation and RelatedDecisions inPortfolioManagement(2),CFA Program 2015

19.CurrencyManagement:AnIntroduction

20.Market Indexes and Benchmarks

page 210

page254

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LEARNING OUTCOME STATEMENTS(LOS)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

14 Managing InstitutionalInvestorPortfoliosThe candidate should be ableto:

a contrast adefined-benefit planto adefined-contribution plan anddiscusstheadvantages and disadvantages of each from the perspectives of the employee andthe employer, (page9)

b discussinvestmentobjectivesandconstraintsfor defined-benefit plans, (page10)

c. evaluatepensionfund risk tolerance when riskisconsideredfrom theperspective

of the1)plan surplus,2)sponsor financialstatusand profitability,3)sponsorand pension fundcommonrisk exposures,4)planfeatures,and5)workforcecharacteristics,(page10)

d prepare an investmentpolicystatementforadefined-benefit plan, (page11)

e. evaluatethe riskmanagementconsiderationsininvesting pensionplanassets.

description,purpose,andsourceoffunds,(page15)

i. comparetheinvestmentobjectivesandconstraintsoffoundations, endowments,insurancecompanies, andbanks,(page16)

j discussthefactors that determineinvestmentpolicy for pensionfunds,foundations, endowments,life and non-lifeinsurancecompanies, and banks

(pages 9 and30)

k preparean investmentpolicystatementforafoundation, an endowment, aninsurancecompany, anda bank,(page16)

1 contrastinvestmentcompanies, commoditypools, and hedge fundstoother

typesof institutionalinvestors,(page29)

m. comparetheasset/liabilitymanagementneedsof pensionfunds, foundations,endowments, insurancecompanies, andbanks,(page29)

n comparetheinvestmentobjectives andconstraintsof institutionalinvestorsgiven relevantdata,suchasdescriptionsof their financial circumstancesandattitudestowardrisk,(page30)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

15 LinkingPensionLiabilitiestoAssets

The candidate should be ableto:

a contrasttheassumptions concerning pensionliability riskinasset-only andliability-relative approachesto assetallocation,(page52)

b discuss the fundamental andeconomic exposuresof pension liabilities andidentifyasset typesthatmimicthese liabilityexposures,(page53)

iosbuiltfromatraditional asset-only perspectivetoportfolios designed relativetoliabilities and discuss why corporationsmay

choosenot toimplement fully the liability mimicking portfolio, (page56)c.

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Book 2 -InstitutionalInvestors, EconomicAnalysis, andAsset Allocation

Readings and Learning Outcome Statements

STUDY SESSION 7

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

16 Capital Market Expectations

Thecandidate shouldbe ableto:

a. discussthe roleof,andaframeworkfor,capital marketexpectations inthe

portfoliomanagementprocess, (page63)

b discuss challengesindeveloping capital marketforecasts,(page64)

c. demonstrate the application of formal tools for setting capital market

expectations,includingstatisticaltools,discounted cash flowmodels,the risk

premiumapproach,and financialequilibriummodels,(page69)

d explain theuseofsurveyand panel methods and judgmentinsettingcapital

market expectations, (page80)

e. discuss the inventory and business cycles, the impact ofconsumerand business

spending, andmonetaryand fiscal policyonthe business cycle, (page81)

f discussthe impact that the phases of the business cycle haveonshort-term/long¬

termcapital marketreturns,(page82)

g explain the relationship of inflationtothe business cycle and the implications of

inflationforcash, bonds,equity, and realestate returns,(page84)

h demonstratetheuseof the Taylor ruletopredict central bank behavior

(page86)

i. evaluate1)the shape of the yieldcurveas aneconomicpredictor and2)the

relationship between the yieldcurveand fiscal andmonetarypolicy, (page87)demonstratethe application ofeconomicgrowth trend analysistotheformulationof capital market expectations, (page88)

k explain howexogenousshocksmayaffecteconomicgrowthtrends,(page90)

1 identify andinterpretmacroeconomic,interestrate,and exchangeratelinkages

betweeneconomies,(page91)

m. discuss the risks facedbyinvestors inemerging-marketsecuritiesand the

countryrisk analysis techniques usedtoevaluate emerging marketeconomies

(page92)

n compare the major approachestoeconomicforecasting, (page93)

o. demonstrate theuseofeconomicinformationinforecastingassetclassreturns.

(page95)

p explain howeconomicand competitive factorscanaffectinvestment markets,

sectors,and specificsecurities,(page95)

q discussthe relative advantages and limitations of the major approachesto

forecasting exchangerates,(page98)

r. recommend and justify changesinthecomponentweights ofaglobal

investmentportfolio basedontrends and expected changesin macroeconomic

factors,(page100)

The topicalcoveragecorresponds with thefollowing CFAInstituteassigned reading:

17.EquityMarketValuation

a. explain thetermsof the Cobb-Douglas production function anddemonstrate

how the functioncanbe usedtomodel growthinrealoutput under the

assumptionofconstant returns to scale,(page119)

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b evaluate the relative importance of growthintotalfactor productivity,incapital

stock,andinlabor input given relevant historicaldata,(page121)

c demonstrate theuseof the Cobb-Douglas production functioninobtaininga

discounted dividend modelestimateof theintrinsicvalueofanequity market

(page123)

useof discounted dividend models andmacroeconomicforecaststo

estimatetheintrinsicvalue ofanequitymarket,(page123)

e contrasttop-down and bottom-up approachestoforecasting the earningsper

shareofanequity marketindex,(page126)

f discuss the strengths and limitations of relative valuationmodels,(page128)

g judge whetheranequity marketis under-,fairly,orover-valued usingarelative

equity valuationmodel,(page128)

d

The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

18 AssetAllocation

a. explain the function of strategicassetallocationinportfoliomanagementand

discuss itsroleinrelationtospecifying and controlling theinvestor’sexposures

tosystematicrisk,(page149)

b comparestrategic and tacticalasset allocation,(page150)

c. discussthe importance ofassetallocationfor portfolio performance, (page150)

d contrasttheasset-onlyandasset/liabilitymanagement (ALM)approaches

to assetallocation and discuss theinvestor circumstances inwhich theyare

commonlyused,(page150)

e. explain the advantage of dynamicover staticassetallocation anddiscussthetrade-offsof complexity andcost,(page151)

f explain how lossaversion,mental accounting, and fear ofregretmayinfluenceassetallocation policy, (page151)

g evaluatereturnand risk objectivesinrelationtostrategicassetallocation

inanasset allocation,(page157)

k demonstrate the application ofmean-varianceanalysistodecide whethertoincludeanadditionalassetclassin anexistingportfolio, (page158)

1

bonds,(page160)

m. explain the importance of conditionalreturncorrelationsinevaluating thediversificationbenefitsofnondomesticinvestments,(page163)

n explainexpected effectsonshare prices,expectedreturns,andreturnvolatilityas

asegmented market becomes integrated with globalmarkets,(page164)

o. explain the majorstepsinvolvedinestablishinganappropriateassetallocation

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Book 2 -InstitutionalInvestors, EconomicAnalysis, andAsset Allocation

Readings and Learning Outcome Statements

q discuss thestructureof theminimum-variancefrontier withaconstraintagainst

shortsales,(page178)

r. formulate and justifyastrategicassetallocation,givenaninvestmentpolicy

statementand capital market expectations, (page180)

assetallocationfor individualinvestorss.

versusinstitutionalinvestorsa

thoseconsiderations,(page186)

t. formulate and justify tacticalassetallocation(TAA)adjustmentstostrategic

assetclass weights, givenaTAAstrategyand expectationaldata,(page190)

aproposedassetallocationinlight of

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading.•

19 Currency Management:AnIntroduction

a. analyze the effects ofcurrencymovements onportfolio risk andreturn.

(page215)

b discuss strategic choicesincurrencymanagement,(page219)

c. formulateanappropriatecurrencymanagementprogram given market facts and

client’s objectives andconstraints,(page222)

currencytrading strategies basedoneconomic fundamentals,

technical analysis, carry-trade, and volatility trading, (page222)

e. describehow changesinfactors underlyingactivetrading strategies affect tactical

tradingdecisions,(page227)

f describe how forwardcontractsand FX(foreign exchange)swapsareusedto

adjust hedgeratios,(page228)d

esusedtoreduce hedgingcostsand modify the returncharacteristicsofaforeign-currency portfolio, (page233)

risk-h describe theuseof cross-hedges, macro-hedges, and minimum-variance-hedge

ratios inportfolios exposedtomultiple foreigncurrencies,(page235)

i. discusschallenges for managing emerging marketcurrencyexposures,(page238)

g-The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

20 Market Indexes and Benchmarks

:tweenbenchmarks and marketindexes,(page254)

b describeinvestment usesofbenchmarks,(page255)

c. comparetypesofbenchmarks, (page255)

a.

e. describe investmentusesof marketindexes,(page256)

f discuss tradeoffsinconstructing marketindexes, (page257)

g discuss advantages and disadvantages of index weightingschemes,(page258)

h evaluate the selectionofabenchmark foraparticularinvestmentstrategy.

(page259)

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The following is a review of the Institutional Investors principles designed to address the learning

outcome statements set forth by CFA Institute This topic is also covered in:

MANAGING INSTITUTIONAL INVESTOR

WARM-UP: PENSION PLAN TERMS

GeneralPensionDefinitions

• Fundedstatusreferstothe dilference between thepresentvaluesof the pensionplan’sassetsand liabilities

• Plan surplusiscalculatedasthe the value of planassetsminusthe value of planliabilities When plan surplusispositive the planisoverfundedand whenit is

negative theplanisunderfunded.

• Fullyfundedrefersto aplan where the values of planassetsand liabilitiesare

approximately equal

• Accumulatedbenefitobligation(ABO)isthe totalpresentvalueofpensionliabilities

todate,assumingnofurther accumulationof benefits.Itisthe relevantmeasureofliabilitiesforaterminated plan

• Projectedbenefitobligation(PBO) istheABOplus thepresentvalue of the additionalliability fromprojectedfuture employee compensationincreasesandisthe valueusedincalculating fundedstatusforongoing(notterminating) plans

• Totalfutureliabilityismorecomprehensive andisthe PBO plus thepresentvalueofthe expectedincrease inthe benefit duecurrentemployeesinthefuture from their

servicetothecompanybetweennowandretirement.Thisisnotanaccountingtermand hasnoprecise definition It could include suchitemsaspossible future changes

inthe benefit formula thatarenot partof the PBO Some plansmayconsideritas

supplemental informationinsettingobjectives

• Retired livesisthenumberofplanparticipantscurrentlyreceiving benefits from the

plan(retirees).

• Activelivesisthe numberof currently employed plan participants whoarenotcurrently receiving pension benefits

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StudySession 6 Cross-Reference to CFA Institute Assigned Reading#14-Managing Institutional Investor Portfolios

LOSl4.j:Discussthefactors that determineinvestmentpolicy for pension

funds, foundations, endowments,life and non-lifeinsurance companies,and

banks

CFA®Program Curriculum, Volume2,page436

Forthe Exam: Pleasenotethat this LOSsimplyreiteratesyoumustknow the relevant

factors affectingthe IPS foreachof the institutionaltypes.

DEFINED-BENEFIT PLANSANDDEFINED-CONTRIBUTION PLANS

LOS14.a:Contrastadefined-benefitplantoadefined-contributionplanand

discuss theadvantagesanddisadvantagesof each from the perspectives of the

employeeand theemployer.

Inadefined-benefit(DB) retirementplan, thesponsor company agreestomake

payments toemployees afterretirementbasedoncriteria(e.g.,averagesalary,numberof

yearsworked)spelledoutin theplan.Asfuturebenefitsareaccrued by employees,the

employeraccruesaliability equaltothepresentvalueof theexpected futurepayments.

Thisliabilityisoffsetby planassetswhicharetheplanassetsfundedbytheemployer’s

contributionsovertime Aplan withassets greater(less)than liabilitiesistermed

overfunded(underfunded).Theemployerbears theinvestmentriskandmust increase

fundingtotheplanwhen the investmentresultsarepoor

Inadefined-contribution(DC) plan,the company agreestomakecontributionsofa

certain amount astheyareearnedby employees (e.g.,1%ofsalaryeachmonth) into a

retirementaccountowned by the participant While theremaybe vestingrules,generally

anemployee legallyownshisaccount assetsandcan movethe funds if he leaves prior

toretirement.For thisreason wesay that theplanhasportability.Atretirement,the

employeecanaccessthefunds butthereis noguaranteeof theamount.Inaparticipant

directed DC plan, the employee makes theinvestmentdecisions andinasponsordirected

DCplan, thesponsorchooses theinvestments Ineithercase,the employee bears the

investmentriskandtheamountavailableatretirement is uncertain inaDCplan The

firmhasnofuturefinancialliability.Thisisthekey differencebetweenaDCplan and

aDBplan.InaDBplan, thesponsorhasthe investmentrisk becauseacertainfuture

benefit has been promised and the firm hasaliabilityas aresult.Afirm withaDCplan

hasnoliability beyond making the agreeduponcontributions

Acash balanceplanis a typeof DBplanin which individualaccountbalances

(accruedbenefit)arerecordedsotheycanbeportable.Aprofit sharing planisa type

of DCplanwhere theemployer contributionisbasedontheprofitsof the company

A varietyof plans funded byanindividualforhisownbenefit, growtaxdeferred,and

canbe withdrawnatretirement(e.g., individualretirementaccounts or IRAs) arealso

considered defined contributionaccounts.

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E LOS I4.b:Discuss investmentobjectivesandconstraintsfor defined-benefit

plans.

CFA®ProgramCurriculum,Volume2,page436The objectives andconstraints inthe IPSforadefined-benefit planarethe standard

onesyouhave learned The objectives of risk andreturn arejointly determined The

constraints canbe separatedintothe plan’stime horizon,taxand regulatorystatus,liquidityneeds,legal and regulatoryconstraints,and uniquecircumstancesof the planthat wouldconstrain investmentoptions

Analysis of these objectives andconstraints,along withadiscussionof the relevantconsiderationsinestablishingthem, iscoveredinthenext twoLOS

LOS I4.c:Evaluate pension fund risk tolerance when riskisconsideredfrom the perspective of the1) plan surplus,2)sponsor financialstatusandprofitability,3)sponsorand pensionfundcommonrisk exposures,4)planfeatures,and5)workforce characteristics

CFA®ProgramCurriculum,Volume2,page437Severalfactors affect the risk tolerance (ability andwillingnesstotakerisk)foradefinedbenefit plan

• Plansurplus Thegreaterthe plan surplus, thegreatertheability of the fundtowithstand poor/negativeinvestmentresults withoutincreases infunding.Thusa

positivesurplus allowsahigher risk tolerance andanegativesurplus reduces risktolerance A negative surplus might wellincreasethe desireof the sponsortotakeriskinthe hope that higherreturnswould reduce the needtomake contributions

Thisisnotacceptable Both thesponsor andmanagerhaveanobligationtomanage

the planassetsfor the benefit of the plan beneficiaries Comparedtofoundationsandendowments,whichmaybe managed aggressively,DBplans will range fromlowtomoderately above-average risk tolerance.Anegativesurplusmay increase

the willingness of thesponsortotakerisk,but thiswillingness doesnotchangeor

outweigh the fact that the planisunderfunded and the fund risk toleranceislowered

resultsarepoor

• Sponsor and pension fundcommonriskexposures.The higher the correlationbetween firm profitability and the value of planassets,theless theplan’srisk

tolerance With highcorrelation,the fund’s valuemayfallatthesame timethat thefirm’s profitability falls andit isleast abletoincreasecontributions

• Plan features.Provisionsfor earlyretirementorfor lump-sum withdrawals decreasethe duration of the plan liabilitiesand,other things equal, decrease the plan’s risktolerance Any provisions thatincreaseliquidity needsorreducetimehorizon reduce

risk tolerance

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• Workforce characteristics The lower theaverage ageof theworkforce,the longer

thetimehorizonand,other things equal, thisincreasesthe plan’s risk tolerance The

higher theratioofretireesdrawing benefitstocurrently working plan participants,

thegreatertheliquidityrequirementsand the lower the fund’s risk tolerance

Conversely, when theratioofactivelivestoretired livesishigher the plan’s risk

toleranceishigher

LOS14.d: Preparean investmentpolicystatementforadefined-benefitplan.

CFA®Program Curriculum,Volume2,page439The elementsofanIPS foradefined benefit fundare notunlike those forIPSorother

investmentfunds

Theobjectivesfor risk andreturnarejointlydetermined with the risk objective limiting

thereturnobjective The factorsaffecting risk tolerance discussed for the previous LOS

should be consideredindetermining the risk tolerance objective includedinanIPSfora

defined benefitplanfund

Whilethesefactors determine the relative risk tolerance for planassets,they donot

address theissueof how risk should be measured foraDBplan and the form thatarisk

objectiveshould take As alreadynoted,fromafirm risk standpoint the correlation of

operating results andplan resultsisimportant If operating results and pension results

arepositivelycorrelated,the firm will findit necessary to increaseplancontributions just

whenit ismostdifficultorcostlytodoso.

The primary objective ofaDBplanisto meetitsobligationtoprovide promised

retirementbenefitstoplan participants The risk ofnotmeeting thisobjectiveis

best addressed usinganasset/liabilitymanagement(ALM)framework UnderALM,

riskismeasured by the variability(standard deviation)of plan surplus Alternatively,

manyplans still lookatriskfrom the perspective ofassetsonly andfocusonthemore

traditional standard deviation ofasset returns.

FortheExam: ALM isamajortopicinthe Level III material Expectitto occur on

theexam,perhapsmorethanonce.This topicreviewdoesnotdiscussit in anydetail

as it iscovered elsewhere InageneralIPS questiononanyportfoliowith definable

liabilities, it isappropriatetomentionthe desirability of lookingat returninterms

of maintainingorgrowing thesurplus and riskasvariability of surplus.Donotmake

itthefocus of theanswer; move onand address therestof theissuesrelevanttothe

question.Also beprepared foraquestionthat doestestthedetails ofALMfoundin

otherpartsof the curriculum

Anotherapproachtosettingarisk objective foraDB plan focusesonits shortfall risk

(theprobability that the planassetvalue will be belowsomespecific levelorhavereturns

belowsomespecificlevel)over agiventimehorizon Shortfall riskmaybe estimated

fora status at somefuture date of fully funded(relativetothePBO),fully funded with

respect tothe totalfuture liability, fundedstatusthat would avoid reportingaliability

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E payments to apension fundguarantor.Alternativeorsupplemental risk objectives

maybe includedtominimizethe volatility of plan contributionsor,in thecaseofa

fullyorover-funded plan, minimizing the probability of havingtomakefuture plancontributions

DB Plan ReturnObjective

The ultimate goal ofapensionplanistohavepensionassets generate returnsufficient

tocoverpension liabilities Thespecificreturnrequirement willdependonthe plan’srisk tolerance andconstraints.Ataminimumthereturnobjectiveisthe discountrateusedto computethepresentvalueof the future benefits.Ifaplanwerefullyfunded,earnsthe discountrate,and the actuarial assumptionsarecorrect,thefully fundedstatuswillremainstable Itisacceptabletoaimforasomewhat higherreturnthat would growthe surplus and eventually allow smaller contributions by the sponsor Objects mightinclude:

• Futurepension contributions.Returnlevelscanbe calculatedtoeliminate the needfor

contributionstoplanassets.

• Pensionincome.Accountingprinciples require pensionexpensesbe reflectedon

sponsors’incomestatements.Negativeexpenses,orpensionincome,canalso berecognized This also leads the sponsortodesire higherreturns,which will reducecontributions and pension expense

Recognize thesemaybegoalsof thesponsorandarelegitimate planobjectivesifnottakento excess.Thereturnobjectiveislimited by theappropriatelevelof risk for theplan and pension plans shouldnottake high risk

DBPlanConstraintsLiquidity.The pensionplanreceivescontributionsfrom theplansponsor and makespayments tobeneficiaries.Anynetoutflowrepresents aliquidity need Liquidityrequirements will be affected by:

• The numberofretired lives Thegreaterthe numberofretireesreceiving benefitsrelativetoactiveparticipants, thegreaterthe liquidity thatmustbe provided

• Theamountofsponsorcontributions The smaller thecorporatecontributions relative

toretirementpayments,thegreatertheliquidity needed

• Planfeatures.Earlyretirementorlump-sumpaymentoptionsincreaseliquidityrequirements

Timehorizon.Thetimehorizonofadefined-benefit planismainly determined bytwofactors:

1. Iftheplanisterminating, thetimehorizonistheterminationdate

2 For anongoingplan, the relevanttimehorizon dependsoncharacteristicsof theplan participants

Thetimehorizonforagoingconcerndefined-benefit planisoften longterm.

Legallyitmayhaveaninfinite life.However,themanagementof thecurrentplanassetsand the relevant time horizonof theportfolio dependonthe characteristicsof

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thecurrentplan participants and when distributionsareexpectedtobe made Some

sponsorsandmanagers viewgoingconcernplansas amultistagetime horizon,one

foractivelives andonefor retiredlives,essentially viewing the portfolioas twosub

portfolios Theactivelives portion of theplan will haveatimehorizon associated

with expectedterm toretirement.The retired lives portion will haveatimehorizon

as afunction of lifeexpectancyfor those currently receiving benefits

Taxes.Most retirementplansare tax exemptand this should be stated Thereare

exceptionsinsomecountriesor someportions ofreturn aretaxed,but othersare not.

Ifanyportionsare taxed,this should be statedintheconstraintand considered when

selectingassets.

Legal and regulatory factors.Inthe UnitedStates,the EmployeeRetirementIncome

Security Act(ERISA)regulates the implementation of defined-benefit plans The

requirements of ERISAareconsistentwith the CFA program and modern portfolio

theoryinregardtoplacing the plan participants first and viewing the overall portfolio

after considering diversification effects Mostcountrieshaveapplicable laws and

regulationsgoverningpensioninvestmentactivity Thekeypointtorememberisthat

when formulatinganIPSforapensionplan, the advisermustincorporate the regulatory

framework existing within the jurisdiction where the planoperates.Consultation with

appropriatelegalexpertsisrequired if complexissues arise Apensionplantrusteeis

afiduciary andassuchmust actsolelyinthe bestinterestsof the plan participants.A

manager hiredtomanageassetsfor the plan takesonthat responsibilityaswell

Uniquecircumstances.Therearenouniqueissuestogeneralize about Possibleissues

include:

• Asmall planmayhave limitedstaff andresourcesfor managing the planor

overseeing outsidemanagers This could bealarger challenge with complex

alternativeinvestmentsthat require considerable due diligence

• Someplansself impose restrictionson assetclassesorindustries.Thisis more

common ingovernmentorunion-related plans

LOS 14.e:Evaluate the riskmanagementconsiderationsininvesting pension

planassets.

CFA®Program Curriculum,Volume2,page 448Another dimensionof DB plan riskis itsaffectonthesponsor.These planscanbe large

with the potentialtoaffect the sponsoring company’s financial health Thecompany

needstoconsidertwofactors

1. Pensioninvestment returnsinrelationtotheoperatingreturnsofthecompany.This

istheissueof correlation ofsponsorbusiness andplanassetsconsideredearlier,

nowviewed from thecompany’sperspective Thecompanyshould also favor low

correlationtominimizethe need for increasing contributions during periods ofpoor

performance The plan should avoid investinginthesponsor company (which is

oftenillegal)andinsecurities inthesameindustryorotherwisehighlycorrelated

with the company

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E 2 Coordinatingpensioninvestmentswithpensionliabilities ThisistheALM issue.By

focusingonmanaging thesurplus and stability of surplus, thecompany minimizes

the probability of unexpectedincreases inrequired contributions

Professor’sNote:This will be discussedingreatdetail elsewhere.At itssimplestthismeansmatching the planassetand liability durations usingfixed-income

investments.Inamoresophisticatedfashion,acloser match may be achieved byKQSW usingrealratebonds and equityasa portionoftheassets.ALMwill also leadtoa

surplusefficientfrontieranda minimum variancesurplus portfolio.Fornowjust

realize the Level III materialishighly integratedand questionsnormallydraw

frommultipleLOSandstudysessions—keep studying

LOS I4.f: Preparean investmentpolicystatementforaparticipant directeddefined-contributionplan.

CFA®ProgramCurriculum,Volume2,page451Constructing the IPS forasponsor-directed DC planissimilartothat for other DBplans, but simpler.Herewewill distinguish between the IPS foraDBplan and the

IPSforaparticipant directedDCplan Withaparticipant directedDCplan, thereis

no onesetofobjectivesandconstraintstobe consideredsincetheymaybedifferent

over timeandacross participantaccounts.The IPSfor thistypeof plan deals with thesponsor’s obligationtoprovideinvestmentchoices(atleast three underERISA)thatallowfor diversification andtoprovide for the freemovementof fundsamongthechoices offered Additionally, thesponsorshould providesomeguidance and educationfor plan participantssotheycandetermine their risktolerance,returnobjectives, andthe allocationof their funds among thevarious investmentchoices offered When the

sponsoroffersachoiceofcompany stock,theIPSshouldprovide limitsonthisas a

portfoliochoicetomaintainadequate diversification(think Enron).

Sooverall theIPSforaparticipant directedDCplan doesnotrelatetoanyindividualparticipantorcircumstance,but outlines the policies and procedures forofferingthe

choices, diversification,and educationtoparticipants that they needtoaddress their

ownobjectives of risk andreturn, aswellastheir liquidity andtimehorizonconstraints

Themanagementof theindividualparticipant balances and setting theirobjectives and

constraints inthe participant directed plan would be handled likeanyother O&Cforan

individual

Incontrast, asponsor-directedDCplan would be treated likeaDBplan.However,

thereisnospecified future liabilitytoconsiderinsetting theobjectives andconstraints

Otherwise,the analysisprocesswould be similarto aDB plan

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HYBRID PLANSANDESOPS

LOS I4.g:Discusshybrid pensionplans (e.g.,cash balanceplans)and

employeestockownership plans.

CFA®Program Curriculum,Volume2,page455Cashbalanceplan.Acash balance planisa typeof defined-benefit plan that defines the

benefitintermsofanaccountbalance.Inatypical cash balance plan,aparticipant’s

accountiscredited eachyearwithapay credit andaninterestcredit Thepaycreditis

usually basedupon thebeneficiary’sage,salary, and/or lengthofemployment,while the

interestcreditisbaseduponabenchmark suchasU.S.Treasuries Thesefeaturesare

similartoDCplans

However,andmorelikeDBplans, the sponsor bears all theinvestmentrisk because

increasesand decreasesinthe valueof the plan’sinvestments (duetoinvestment

decisions, interestrates, etc.)donotaffect the benefitamountspromisedtoparticipants

Atretirement,the beneficiarycanusually electtoreceivealump-sumdistribution,

whichcanbe rolledintoanotherqualified plan,orreceivealifetimeannuity

Employeestockownership plans(ESOPs).AnESOPisa typeof defined-contribution

plan that allows employeestopurchase the companystock, sometimesat adiscount

from market price The purchasecanbe with before-orafter-tax dollars The final

balanceinthe beneficiary’saccountreflects theincrease inthe value of the firm’s stockas

wellascontributions during employment ESOPsreceivevaryingamountsofregulation

indifferentcountries

Attimesthe ESOPmaypurchasealarge block of the firm’s stock directly fromalarge

stockholder,suchas afounding proprietororpartnerwhowants toliquidateaholding

AnESOPisan exceptiontothegeneralaversion toholdingthesponsor’ssecurities in a

retirementplan It doesexposethe participantto ahigh correlation between planreturn

andfuture jobincome

FOUNDATIONS

LOS I4.h:Distinguishamongvarioustypesoffoundations,withrespectto

theirdescription,purpose, andsourceof funds

CFA®Program Curriculum,Volume2,page456

Fromaninvestmentmanagementperspectiveandatypicalsetof objectives and

constraints,foundations and endowmentsaregoingtobe treated thesame.Theterms

arefrequently used interchangeably, thoughinthe United States thereare nuances

of legal distinction.Ingeneral foundationsaregrant-makingentitiesfunded by gifts

andaninvestmentportfolio Endowmentsarelong-term funds owned byanon-profit

institution (andsupporting thatinstitution).Bothare notfor profit,serveasocial

purpose,generallyarenottaxed if theymeetcertain conditions, areoften perpetual, and

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Figure1containsasummaryof the characteristics of the four basictypesoffoundations.1

Figure1 :Types of Foundations and Their Important Characteristics

AnnualSpendingRequirement

TypeofFoundation Description Purpose SourceofFunds

Grants to

charities,

educational

institutions, social organizations, etc.

5% of assets;

expenses cannot

becountedin thespendingamount

Private or

family Independent

Same as

independent;

grants can beusedto further the corporate

sponsor’sbusiness

interests

Closely tied to

thesponsoring corporation

Same as

independent foundations

Companysponsored

Corporate sponsor

Mustspendat least 85% of dividend and interest income for its own

operations; may

also besubjectto

spending3.33% of

assets

Established for the sole purpose

offundingan organization(e.g.,

a museum, zoo, public library) or

some ongoing research/ medical

initiative

Same as

independentOperating

Publiclysponsoredgrant-awarding organization

Fund social, educational,

religious, etc.

purposes

General public,including largedonors

LOS14.i:Compare theinvestmentobjectivesandconstraintsoffoundations,endowments, insurancecompanies, and banks

LOS I4.k:Preparean investmentpolicystatementforafoundation,an

endowment,aninsurancecompany, andabank

CFA®ProgramCurriculum, Volume2,page458

FoundationObjectivesRisk Because thereare nocontractually defined liabilityrequirements,foundations

may bemoreaggressive than pensionsonthe risk tolerance scale.If successfulinearninghigherreturnsthefoundationcanincreaseits socialfundingin thefuture If

1. Basedupon Exhibit 2,“Managing InstitutionalInvestor Portfolios,”byR Charles Tschampion, CFA, Laurence B Siegel, DeanJ.Takahashi, andJohnL Maginn, CFA, from Managing Investment Porfolios:A Dynamic Process,3rdedition, 2007 (CFA Institute,2015Level III Curriculum,Reading14,Vol.2, p 457).

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unsuccessful the foundationsuffers andcanfund lessinthefuture.Ineithercasethe

benefit and riskaresymmetrically borne The board of the foundation(andmanager)

willgenerally consider thetimehorizon and othercircumstancesof the foundationin

setting the risk tolerance

Return Timehorizonis animportant factor If the foundationwascreatedtoprovide

perpetualsupport,the preservation of real purchasing powerisimportant One useful

guidelineisto set aminimumreturnequaltothe requiredpayoutplus expected

inflation and fundexpenses.This might be done by either addingorcompounding the

returnelements.(Note:thisissue isdiscussed underendowments)

FoundationConstraints

Time horizon.Except forspecial foundations requiredtospend downtheirportfolio

withina setperiod,mostfoundations have infinitetimehorizons.Hence,theycan

usually tolerate above-average risk and choosesecuritiesthat tendtooffer highreturns as

wellaspreservation ofpurchasingpower

Liquidity A foundation’s anticipated spending requirementistermeditsspendingrate.

Manycountriesspecifyaminimumspendingrate,and failureto meetthis will trigger

penalties.For instancethe United States hasa5% ruletospend 5% of previousyear

assets.Othersituationsmayfollowasmoothing ruletoaverageoutdistributions

Forongoing foundations thereisgenerallyaneedtoalsoearnthe inflationrate to

maintainreal valueof the portfolio and distributions Earning the required distribution

and inflationcanbe challenging with conflicting interpretations for risk Itmayargue

for high riskto meetthereturn target orless risktoavoid the downside of disappointing

returns.

Many organizations finditappropriatetomaintainafractionof the annual spendingas

acashreserve inthe portfolio

Taxconsiderations Except for the fact thatinvestment incomeof private foundations

iscurrently taxedat 1% inthe UnitedStates,foundationsarenottaxableentities.One

potentialconcernrelatestounrelated businessincome,whichistaxableatthe regular

corporate rate.On average,taxconsiderationsare not amajorconcernforfoundations

Legal and regulatory Rulesvarybycountryandevenbytypeof foundation In the

United Statesmost stateshave adopted the UniformManagementInstitutional Funds

Act(UMIFA)asthe prevailing regulatory framework.Mostother regulationsconcern

thetax-exempt statusof the foundation Beyond thesebasics,foundationsarefreeto

pursue theobjectives theydeem appropriate

Professor’sNote: We arediscussingfoundationsand endowmentsastwodifferent

institutiontypes,asdoneinthe CFAtext. There may someday beaquestionon

theexamregarding thesubtle,technicaldifferences.Wedonotbelieve that hasyet

occurred The waytheyaremanaged and theissuestoconsider areoverwhelmingly

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E ENDOWMENTSANDSPENDINGRULES

Endowmentsarelegalentitiesthat have been funded for the expressed purpose ofpermanently funding the endowment’s institutional sponsor(anotfor profit that will

receivethe benefitsof the portfolio) Theintent istopreserveassetprincipal valuein

perpetuity andto usetheincomegenerated for budgetarysupportof specificactivities

Universities,hospitals,museums,and charitable organizations oftenreceiveasubstantialportion of their funding from endowments Spending from endowmentsisusuallyearmarkedfor specific purposes and spending fluctuationscan createdisruptionsintheinstitutional recipient’s operating budget

Mostendowments(and foundations)havespending rules.In theUnitedStates,

foundations haveaminimumrequiredspendingrule but endowmentscandecide theirspendingrate,changeit,orjust failto meetit

Threeformsof spending ruleareasfollows:

• Simple spending rule

Themoststraightforward spending ruleisspendingtoequal the specified spendingratemultiplied by the beginning period market value of endowmentassets:

spendingt=S(marketvaluetl)

where:

S =thespecified spendingrate

• Rolling3-year averagespending rule

This modificationtothe simple spending rulegenerates aspendingamountthatequals the spendingratemultiplied byanaverage of the three previous years’ market

valueof endowmentassets.The ideais toreduce thevolatilityof what theportfoliomustdistribute and of what thesponsorwillreceiveandcanspend:

market valuet_1+market valuet_2+marketvaluet_3spending,.= (spending rate)| 3

• Geometricspendingrule

The rolling3-yearrulecanoccasionally produce unfortunateconsequences

Considera caseofdramatic,steady declineinmarket valuefor threeyears.It wouldrequireahigh distributioninrelationto currentmarket value The geometricspending rule givessomesmoothing but less weighttoolder periods It weightsthe prior year’s spending level adjusted for inflation byasmoothingrate,which

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isusually between 0.6 and0.8, aswellasthe previous year’s beginning-of-period

Risk Risk toleranceforanendowmentisaffected by the institution’s dependenceon

funding from the endowment portfolioto meetitsannual operating budget Generally,

if the endowment providesasignificant portion of the institution’s budget, ability

totolerate riskisdiminished The endowmentisconcernednotonly with portfolio

volatility butalsospending volatility.(Thereal purposeofthesmoothingrules isto

allowmorerisk and portfolio volatility but smooth distributionstotheinstitution,

allowing theinstitutiontobetter plan and budget.)

Becausethetimehorizonfor endowmentsisusuallyinfinite,the risk toleranceofmost

endowmentsisrelatively high The needto meetspending requirements and keepup

with inflationcanmakehigherrisk appropriate

Likeafoundation,the ultimate decisionis uptothe board(andmanager)

Return Aspreviouslyindicated,oneof the goals of creatinganendowmentistoprovide

a permanent assetbaseforfundingspecificactivities Attentiontopreserving the real

purchasing power of theassetbaseisparamount.

Atotalreturnapproachistypical The form ofreturn, income,realized, orunrealized

price changeisnotimportant If thereturnobjectiveis achieved, inthe longrunthe

distributions will be covered Itisnotnecessary in anyoneyearthat theamountearned

equal the distribution However thelong-termnaturealso requires the inflationratebe

covered(earned aswell).The inflationrateusedisnotnecessarily the general inflation

ratebut should be theratereflectingthe inflation raterelevanttowhat the endowment

spends.Forexample if the spending for healthcare isthe objective and healthcare

inflationis 6%, use6%

Whileit istypicaltoadd the spendingrate,relevant inflationrate,andanexpense

rateif specified, others argue for using thehighercompound calculation Monte Carlo

simulationcananalyze path dependencyandmultipletimeperiodstoshedsomelight

onthisissue.Forexample if theassetvalue declines and the spendingamountis fixed,

the distribution disproportionately reduces thesizeof the portfolio available This

suggeststhereturn targetbesetsomewhat higher thanisconventionally done

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E EndowmentConstraints

Timehorizon.Becausethe purpose ofmostendowment fundsistoprovidea permanent sourceof funding, thetimehorizonfor endowment fundsistypically perpetual

Liquidity requirements The liquidity requirements ofanendowmentareusually low

Onlyemergencyneeds andcurrentspending require liquidity.However,large outlays(e.g., capital improvements)mayrequirehigherlevelsof liquidity

Tax considerations Endowmentsaregenerallytax exempt.Thereareexceptions andthese mightoccurand be describedinagivensituation.In theUnitedStates, some

assets generateunrelated businessincome.Inthatcase,UnrelatedBusinessIncomeTax

(UBIT) mayhavetobe paid Ifa casedoes include detailson taxation, notethisas a tax

constraintand consider theafter-taxreturnof thatasset.

Legal and regulatory considerations Regulationislimited Foundations andendowments have broad latitudeto setandpursuetheirobjectives.Inthe UnitedStates,501(c)(3) taxregulationsrequire earnings fromtax-exempt entities notbe usedfor

private individuals.Moststateshave adopted the Uniform Management InstitutionalFund Act(UMIFA)of 1972asthe governing regulation for endowments Ifnospecificlegal considerationsarestatedinthecase,for U.S.entities, stateUMIFAapplies Other

countries mayhave other laws

Unique circumstances Duetotheirdiversity,endowment funds have many uniquecircumstances.Socialissues(e.g., defensepolicies and racialbiases) aretypicallytakenintoconsideration when deciding uponassetallocation The long-termnature

of endowments andmanyfoundations have leadtosignificantuseof alternative

investments.Thecostandcomplexity of theseassetsshould be considered.Theygenerallyrequire activemanagementexpertise

INSURANCE COMPANIES

Insurance companies sellpolicies that promisea payment tothe policyholder ifacoveredeventoccursduring the life(term,period of coverage) of the policy With lifeinsurance

thateventwould be the deathof the beneficiary With automobileinsurancethat might

beanaccidenttothe automobile In exchange forinsurance coveragethe policyholder

paystheinsurera payment(premium) Those fundsareinvested till needed forpayouts

andtoearna returnfor thecompany

Historically therewerestock companies owned by shareholders seekingtoearnaprofitfor the shareholders and mutuals owned by the policyholder and operated only for thebenefitof the policyholders.Inrecentyearsmanymutuals have been demutualized and

become stock companies

LIFE INSURANCECOMPANIES

Lifeinsurancecompanies sellinsurancepolicies that provideadeath benefittothosedesignatedonthe policy when the covered individual dies.A varietyoftypesof life

insurance existthatmayhave differenttimehorizons and liquidity needs Itiscommon

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to segregatetheinvestmentportfolio bytypeof policy(lineofbusiness)andinvestto

match the needs of that product.Someof the important policytypesand implications

for portfoliomanagementinclude:

• Whole lifeorordinary life generally requiresalevelpaymentof premiumsover

multipleyearstothe companyandprovidesafixedpayoffamount atthedeathof

thepolicyholder These policies often includeacash valueallowingthepolicyholder

toterminatethe policy andreceivethat cash value Alternatively the policyholder

maybe abletoborrow the cash value The cash value builds upoverthe lifeof the

policyat acreditingrate.

Thereareportfolio implicationstothesefeatures The company faces competitive

pressuretoofferhigher creditingrates to attract customers,whichcreates aneedfor

higherreturn onthe portfolio Inaddition,disintermediation riskoccursduring

periods ofhighinterestrateswhen policyholdersare morelikelytowithdraw cash

value causing increased demand for liquidity from the portfolio Highratesarealso

likelytobe associated with depressed market valuesinthe portfolio While duration

of whole lifeisusually long, the combination of policy features and volatileinterest

ratesmakes theduration andtimehorizonof the liabilitiesmoredifficulttopredict

Overall,competitive market factors and volatileinterestrateshave ledtoshortening

thetimehorizon and durationof theinvestmentportfolio

• Term lifeinsuranceusually providesinsurance coverageon ayearbyyearbasis

leadingtoveryshort durationassets tofund the short duration liability

• Variablelife,universallife,and variable universal life usually includeacash value

build up andinsurance (likewholelife),but the cash valuebuildupislinkedto

investmentreturns.Thefeaturesareless likelytotriggerearly cash withdrawals but

increasetheneedtoearncompetitivereturnsontheportfoliotoretainandattract

newcustomers.

Life Insurance CompanyObjectives

Risk Public policyviews insurance company investmentportfoliosasquasi-trustfunds.

Having the abilitytopaydeath benefits when dueisacriticalconcern.The National

AssociationofInsurance Commissioners (NAIC)directs lifeinsurancecompaniesto

maintainanassetvaluationreserve (AVR)as acushion against substantial losses of

portfolio valueorinvestment income.Worldwide themovementistowards risk-based

capital,which requires the companytohavemorecapital(andlessfinancial leverage)the

riskier theassetsinthe portfolio

• Valuationrisk andALMwill figure prominentlyin anydiscussion ofrisk,and

interestraterisk will be the primeissue.Any mismatch between duration ofassets

andof liabilities will make the surplus highly volatileasthe changeinvalueof the

assetswillnottrack the changeinvalueof liabilities whenrateschange The resultis

the durationofassetswill becloselytiedtothe durationof liabilities

• Reinvestmentrisk will be important forsomeproducts.Forexample, annuity

products(sometimescalled guaranteedinvestmentcontractsor GICS)payafixed

amount at amaturitydate (Effectively theyarelikeazero-coupon bond issued by

the company.) The companymustinvestthe premium and build sufficient valueto

payoffatmaturity Asmost assetsinthe portfolio will be coupon-bearingsecurities,

the accumulated valueinthe portfolio will also dependonthereinvestment

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E ALM isthe prime tool for controlling both of these risks The risk objective will

typicallystatethe needtomatchassetandliability durationorclosely controlany

mismatch

Other riskissuesare:

• Cash flow volatility Lifeinsurancecompanies havealow toleranceforanyloss

ofincomeordelaysincollectingincomefrominvestment activities.Reinvesting

interestoncash flow comingin isamajorcomponentofreturnoverlong periods

Most companies seekinvestmentsthat offerminimumcash flowvolatility

• Credit risk Credit qualityisassociated with the ability of theissuersof debttopay

interestandprincipalwhendue.Creditanalysisisrequiredtogaugepotentiallosses

ofinvestment incomeand has beenoneof the industry’sstrongpoints Controllingcredit riskisamajorconcernfor lifeinsurance companiesandisoften managedthroughabroadly diversified portfolio

Traditionally lifeinsurance companyportfolioswereconservatively invested but businesscompetitionincreasesthepressuretofind higherreturns.

Return.Traditionallyinsurancecompanies focusedonaminimumreturnequaltothe actuaries’ assumedrateof growthinpolicyholderreserves.Thisisessentially thegrowthrateneededto meetprojectedpolicypayouts.Earn less and thesurplus willdecline.Moredesirableisto earn a netinterestspread,a returnhigher than the actuarialassumption.Consistenthigherreturnswouldgrowthe surplus and give thecompany

competitive advantageinoffering productstothe marketat alowerprice(i.e.,lower

premiums).

Whileit istheoretically desirabletolookattotalreturnit canbe difficulttodointhe

insuranceindustry Regulation generally requires liabilitiestobe shownat someversion

of book value Valuingassets atmarket value but liabilitiesatbook valuecan createunintendedconsequences

Thegeneralthrustisto segmenttheinvestmentportfolio by significant line of businessandsetobjectives by the characteristics of that line of business Theinvestmentsareheavily fixed-income oriented withanexception Thesurplusmaypursuemore

aggressiveobjectives suchasstock,realestate,and private equity

Life Insurance CompanyConstraintsLiquidity Volatility and changesinthe marketplace have increased theattentionlife

insurancecompaniespaytoliquidityissues.Thereare twokeyissues:

• Companiesmustconsider disintermediation riskaspreviously discussed This

has ledtoshorterdurations,higher liquidityreserves,and closer ALMmatching

Durationand disintermediationissuescanbe interrelated Consideracompany

withassetdurationexceedingliability duration Ifinterestrates rise, assetvalue willdeclinefaster than liability value If the company needstosellassets tofundpayouts

itwould be doingso atrelatively low values and likelyalossontheassetsale.A

mismatchof duration compounds the problem of disintermediation

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• Assetmarketability risk has also becomealarger consideration Traditionally life

insurancecompanies held relatively large portions of theportfolioinilliquidassets.

The increased liquidity demandsonthe portfolios have leadto greateremphasison

liquidassets.

Thegrowthofderivativeshasleadmanycompaniestolookforderivative-basedrisk

managementsolutions

Timehorizon Traditionally longat20-40years, ithas become shorter for all the

reasonsdiscussedpreviously Segmentation and duration matching by line of businessis

thenorm.

Tax considerations Lifeinsurancecompaniesaretaxableentities.Laws varybycountry

butoften thereturnuptothe actuarial assumedrateistaxfree and above thatistaxed

The realityisquitecomplex andtaxlawsarechanging Ultimately after-taxreturnisthe

objective

Professor’sNote: Again remember theCFAexamdoesnotteachorpresumeyouare

atax orlegalexpert.Onlystatewhatyou aretaught and rememberifa casebrings

upcomplexissuesto statethe needtoseekqualifiedadvice Candidatesareexpected

toknow whentoseek help,not toknow what the advice will be.Hint:forthe legal

constraintforinsurancecompanies,generallystatecomplex andextensive

Legal and regulatoryconstraints.Lifeinsurancecompaniesareheavily regulated.Inthe

UnitedStates, it isprimarilyatthestatelevel These regulationsare verycomplex and

maynotbeconsistentby regulator Regulations often address the following:

• Eligibleinvestmentsbyassetclassaredefined andpercentagelimitsonholdingsare

generally stated.Criteriasuchastheminimum interest coverage ratioon corporate

bondsarefrequentlyspecified

• In the UnitedStates,the prudentinvestorrule has been adopted bysomestates.

This replaces the list of eligibleinvestmentsapproach discussedinthe bullet above

infavor of portfolio riskversusreturn.(Essentially modern portfolio theoryasthe

riskisportfolio risk including correlationeffects)

• Valuationsmethodsarecommonly specified(and are some versionof book value

accounting).Becausetheregulatorsdo consider thesevaluations, itlimits theability

tofocusonmarket value and totalreturnof the portfolio

Theseregulatoryissuesdosignificantlyaffect theeligibleinvestmentfor and theasset

allocationof the portfolio

Unique circumstances Concentrationof product offerings, companysize,and levelof

surplusare someof themost commonfactors impacting each company

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E NON-LIFEINSURANCECOMPANIES

Professor’sNote:Non-lifecompaniesincludehealth,propertyandcasualty, and

suretycompanies.Treat them likelifecompaniesexceptwhere specificdifferences

• Howeverthereisoftenalong tailtothepolicy.Aclaim couldbe filed and takeyears

toprocess beforepayout.Thinkofacontentiousclaim thatislitigated foryears

beforepayout.

• Many non-lifepolicies have inflation risk Thecompany may insurereplacementvalue of the insureditemcreating lesscertainandhigherpayoffsonclaims Incontrastlifeinsurancepoliciesaretypically forastatedfacevalue

• Lifeinsurancepayoutsaregenerallyverypredictableinamountbut hardertopredict

intiming Non-lifeishardtopredictinboth dimensionsofamountand timing

• Non-lifeinsurershaveanunderwritingorprofitability cycle Company pricing

of policies typicallyvaries overa3-to5-yearcycle During periods ofintense

business competition, priceson insurance arereducedtoretainbusiness Frequentlythe pricesareset toolow and leadtolossesas payoutsonthe policiesoccur.The

companythenmustliquidate portfolioassets tosupplement cash flow

• Non-life business riskcanbeveryconcentratedgeographicallyorwithregardtospecificevents (whichwill be discussed underrisk)

The conclusion will be that the operating results for non-lifeinsurancecompaniesare morevolatilethan for lifeinsurancecompanies, durationis shorter,liquidity needsare

both larger and less predictable

Non-Life Insurance CompanyObjectives

Risk Like lifecompanies,non-life companies haveaquasi-fiduciaryrequirement

andmustbe investedto meetpolicy claims.However,thepayoffsonclaimsarelesspredictable.Forexampleacompanythatinsures property in aspecificareathatisthen

hit withsevereweathercanexperience sudden high claims andpayouts.Also there

isinflationriskif thepayoutisbasedonreplacementcostof the insureditem.Keyconsiderationsare:

1 The cashflowcharacteristicsof non-life companiesareoftenerraticandunpredictable.Hence,risktolerance,asitpertainstolossof principal and declining

investmentincome,isquite low

2 Thecommonstock-to-surplusratiohas been changing Traditionally the surplus mighthave been investedinstock.Poorstock marketreturnsinthe 1970s and regulator

concernsleadtoreduced stock holdings Bull marketsinthe 1990s only partiallyreversed this trend

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Professor’sNote:The underlyingissue isthat thenon-lifebusinessisboth cyclicalanderraticinprofitability and cashflow. Theinvestmentportfolio seekstosmoothprofitability andprovideforunpredictableliquidityneeds Unfortunately thereis

noobvious waytodo this

Return.Historicallyanon-life company acted liketwo separatecompanies,an insurance

company andan investmentcompany.Investmentreturnswerenotfactoredinto

calculating policy premiums charged forinsurance.Things have changed but thereis

stillamixof factorsaffectingthereturnrequirement: the competitive pricing of the

insuranceproduct, need for profitability, growth of surplus,tax issues,and totalreturn.

Complicating factors impacting non-lifeinsurancecompanyreturnobjectives that do

notarisefor lifeinsurancecompanies include:

• Competitive pricing policy.High-return objectivesallow thecompanytocharge

lower policy premiums andattractmore business,but when highreturnsareearned

the companies tendto cutpremiums (Essentially thisisthe underwriting cycle)

• Profitability.Investmentincomeandreturn ontheinvestmentportfolioareprimary

determinants ofcompanyprofitability They also provide stabilitytooffset the

less stable underwriting cycle of swingsinpolicy pricing Thecompanyseeksto

maximizereturnonthe capital and surplusconsistentwith appropriate ALM

• Growthof surplus Higherreturnsincreasethecompany’ssurplus This allows the

companytoexpand theamountofinsurance itcanissue.Alternativeinvestments,

commonstocks,and convertibleshavebeenusedtoseeksurplus growth

• After-taxreturns.Non-lifeinsurancecompaniesaretaxableentitiesand seek

after-taxreturn.Atone timedifferentialtaxationrulesinthe United States ledto

advantagesinholdingtax-exemptbonds and dividend paying stocks Changesin

regulation have reduced this

• Totalreturn.Activeportfoliomanagementand totalreturnarethe general focus

foratleastsomeof the portfolio Interestingly thereturnsearnedacrosscompanies

arequite varied This reflects wider latitude by non-life regulators,a morevaried

productmix,varyingtax situations,varyingemphasisinmanaging for totalreturn

orforincome,anddifferingfinancialstrengthof the companies

Non-Life Insurance CompanyConstraints

Liquidity needsarehigh given theuncertain business profitability and cash flow needs

Thecompanytypically1)holds significantmoneymarketsecuritiessuchasT-bills and

commercialpaper,2)holdsaladderedportfolio of highly liquidgovernmentbonds,and

3)matchesassetsagainst known cash flow needs

Timehorizonisaffected bytwofactors Itisgenerally short duetothe short durationof

the liabilities

However,therecanbeasubsidiaryissuetoconsiderinthe United States The

assetduration(time horizon)tendstocycle with swings from losstoprofitinthe

underwriting cycle and decreasingorincreasinguseoftax-exemptbonds In periods

ofloss,thecompanywillusetaxable bonds andowenotaxes.Whenprofitable, the

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E Tax considerations Non-lifeinsurancecompaniesaretaxableentities.Applicabletax

rulesinthe UnitedStateshave been changing After-taxreturnisthe objective

Legal and regulatoryconstraints.Regulatory considerationsarelessonerousfor non-life

insurance companiesthan for lifeinsurance companies Anassetvaluationreserve (AVR)

isnotrequired, but risk-based capital(RBC)requirements have been established Non¬

life companiesaregiven considerable leewayinchoosinginvestmentscomparedtolife

insurancecompanies

Uniquecircumstances.Thereare nogeneralizationstomake

ConclusionThe portfolioisfirst structuredfor liquidity needs.Aportfolio of bonds and stocksis

usedtoincreasereturn.Themanagementof the portfoliomustbe coordinated with thecompany’s business needs

BANKS

FortheExam: Abank IPSissomewhat unique Itisdriven by the fundamentals ofthe banking business and derives from the role of theinvestmentportfoliointhatbusiness Thisreview is notreally aboutmanagingabankportfolio but aboutthe

IPS.Itmaynotreflect the approach ofevery bank,butit isthe approach forexam

questions

The objectives andconstraintsofabank’ssecuritiesportfolio derive fromitsplace

inthe overallassetliabilitystructureof the bank Banksare inbusinesstotakein

deposits(liabilities),make loans(assets),and makeaprofit primarily fromaspread offtheinterestearnedon assetsless paidonliabilities.Apotential problemexists intherelationship betweenabank’sassetsand liabilities Liabilitiesaremostlyintheform ofshort-term deposits, whileassets (loans)canbe fairly longterminnatureand illiquid

The loans also generally offerreturnshigher thancanbe earnedonthesecurities in

which banksinvestandareriskier This leadsto asignificant mismatchinasset-liability

durations,liquidity, and quality

The bank’ssecurityportfolioisaresidualuseof funds(i.e.,excessfunds that havenotbeen loanedout or arerequiredtobe heldas reservesagainstdeposits) Whileit

isdesirabletoearnan attractivereturnonthe portfolio, theprimarypurposeof the

securitiesportfolioistoaddress the mismatchof liabilities (deposits) and the primaryassets (loans).

Duration,CreditRisk, Income,andLiquidity

Itisgenerallyeasierand timeliertoadjust the characteristics of theinvestmentportfoliothanit istoadjust the characteristics of the liabilitiesorof the otherassets(the loans)

Generally theinvestmentportfoliomanageradjuststhe bank’sinvestmentportfolio

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duration suchthat overallassetdurationiskeptinthe desired relationshiptoliability

duration

In theoryifamanagerforecasts increasinginterestrates,shecandecrease the durationof

theportfolioto setthe overallassetduration below the liability duration If theinterest

ratepredictioniscorrect,theassetswill decline lessthan the liabilities foran economic

gain The realityisthisisveryrisky andisnotdoneordoneinverylimited fashionfor

banks.Bank leverageisveryhigh withverylow equity capitalto assets.Thus the primary

goalistoadjust the duration of theportfolio such that overall duration ofassetsmatches

liability duration

In additiontodurationmanagement, abankusesits securityportfoliotomanage

the credit risk and diversificationofitsassets.Forexample,abank’s loanscan

become geographically concentrated To offset the associated credit risk and lack of

diversification,management canminimizethe credit risk andmaximizediversification

using thesecuritiesportfolio

Loansarerelativelyilliquid andthe investmentportfolio will emphasizeveryliquid

securitiesto compensate.Ingeneralthe bankinvestmentportfolioisheavilyor

exclusively short-termgovernmentsecurities

Lastly, the banksecuritiesportfolioscangenerate incomefor thebank,but this should

beaconsiderationafter the otheritemsdiscussed here have been addressed

Bank Risk Measures

Professor’sNote:Banksareheavily regulated and the regulatorsdefinevariousreportingmeasuresforthe bank Followingisabriefdiscussionofsomeofthem

VARisdiscussed extensivelyinotherpartsofthe curriculum andisacommon sourceofquestions

Leverageadjusted durationgap(LADG) receivesonlyapassingcommentin theCFAtextandnomathiscovered Itisjustdurationofassets versusliabilitiestakinginto accountthat they willnotbeofequalsize. Theconceptofasset versus

liabilitydurationis assetliabilitymanagement (ALM),andit isvery important

ontheexam.LADGisjustaspecialized applicationofALMused bysomebankregulators

Bothassetsand liabilitiesare sensitivetochanginginterestrates.Banksmustcontinually

monitortheirinterestraterisk Valueatrisk(VAR) is onecommonly used tool

Regulatorsoftendefine and specify calculation methodology,setminimumtarget levels,

and imposerestrictionsiftargetsarenot met.

Leverage-adjustedduration gapisanother suchregulatorytool Itisdefinedasthe

durationof the bank’sassetsless the leveraged duration of the bank’s liabilities:

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LADG=Dassets

where:

LADG =leverage adjustedduration gap

=durationof the bank’sassets

= durationofthebank’s liabilities

=leveragemeasure(marketvalueof liabilitiesovermarket valueofassets)LADGshould predictthetheoretical changein fairmarket valueofbank equity capital

ifinterest rateschange.If LADGis:

• Zero,equity shouldbe unaffected byinterestratechanges

• Positive,equitychangeis inverse to rates(e.g.,ratesup equitydown).

• Negative, equityvaluemovesin thesamedirectionas rates.

DassetsLA

THEBANK IPS

BankObjectivesRisk The acceptable risk should besetinanALMframework basedontheeffectonthe

overall bank balance sheet Banksusuallyhaveabelow-averagerisk tolerancebecausetheycannotlet losses in the securityportfoliointerfere with theirabilityto meettheirliabilities

Return Thereturnobjectivefor the bank securitiesportfolioistoearnapositiveinterestspread Theinterestspreadisthe difference between the bank’scostoffunds andtheinterestearnedonloans and otherinvestments

Bank ConstraintsLiquidity.Abank’s liquidity needsaredriven by deposit withdrawals and demand forloansaswellasregulation The resulting portfolioisgenerally short and liquid

Timehorizon Thetimehorizonisshort and linkedtothe durationof the liabilities

Taxes Banksaretaxableentities.After-taxreturnisthe objective

Legal and regulatory Banksinindustrializednationsarehighly regulated Risk-basedcapital(RBC)guidelines require bankstoestablish RBCreservesagainstassets;the

riskier theasset,thehighertherequired capital.This tilts theportfolio towards quality,short-term,liquidassets.

high-Unique Thereare noparticular generalissues

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ASSET/LIABILITY MANAGEMENTFORINSTITUTIONALINVESTORS

LOS14.m:Compare the asset/liabilitymanagementneedsofpension funds,

foundations, endowments, insurancecompanies, and banks

ALMisthepreferredframeworkforevaluation portfolios withdefinable,measurable

liabilities Focusingon asset returnandrisk isnotsufficient.Thefocus shouldbeon

surplus and surplus volatility.Ata minimum, assetand liability duration should be

matchedtostabilizesurplus Dependingonrisktolerance, active managementthrough

defined deviationsinassetand liability duration mightbeusedtoexploit expected

changesininterest rates.

Hint:this isdiscussedinmultiple studysessionsand perhapsbestcoveredinfixed

incomewithnumericcalculations

DB pensionplans,insurance companies,and banksarethemostsuitedtotheALM

approach

INVESTMENTCOMPANIES

LOS14.1:Contrast investmentcompanies, commoditypools,andhedgefunds

toothertypesof institutionalinvestors

CFA®Program Curriculum,Volume2,page498

Theinstitutional portfolios discusseduptonow manage moneyforaparticularentity

(e.g.,abankor an insurancecompany).Categorizingbygroup offers usefulinsights.All

DBplans have similaritiesintheir objectives and sharecommonissuesof analysis In

contrast, investmentcompanies, commoditypools, and hedge fundsareinstitutional

investorsbutarejust intermediaries that pool andinvestmoney forgroups ofinvestors

andpassthereturnsthroughtothoseinvestors.Unlike other institutionalinvestorsitis

notpossibletogeneralize about their policystatements.

• Investment companiesaremutual funds andinvest inaccord withtheirprospectus.

Therearemutualfunds,for example,tofit justaboutanyequityorfixed-income

investmentstyle, from small-cap growth fundstolarge-cap value fundstofunds that

investexclusivelyinoneofavariety ofsectors orindustries

• Commoditypoolsinvest incommodity-relatedfutures, optionscontracts,and

relatedinstruments

• Hedgefundsarehighlydiverse Grouping allhedgefundtypesunder thesame

general heading explains virtually nothingaboutwhat each funddoes.Hedge funds

gathermoney frominstitutional and wealthy individualinvestorsandconstruct

various investmentstrategies aimedatidentifying and capitalizingonmispriced

securities

Allthreeof thesepoolmoney fromagroup ofinvestorsandpursue thestated objective

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INVESTMENT POLICIESOF INSTITUTIONALINVESTORSVO

LOS I4.j:Discussthe factorsthat determineinvestmentpolicyfor pensionfunds, foundations, endowments,life and non-lifeinsurancecompanies, and

Figure2:FactorsAffectingInvestmentPoliciesofInstitutionalInvestors

Institutional Investor Type

Non-Life

Insurance Companies

Defined-Benefit

Plans

Endowment LifeInsurance Funds Companies

Commercial Banks

IPS

Foundations Component

Actuarial

rate A capital gains focus

when the

fund has low liquidity needs and younger Return workers An

income focus

(duration

matching) when there are

high liquidity needs and older workers.

need for high current

Total

return is appropriate.

a positive interest rate

spread.

Fixed-income

segment:

“spread management”

and actuarial assumptions.

Equity

segment: grow the surplus/

supplement funds for liability claims.

liquidity

needs and

cannot suffer losses in the

and company balance sheet.

to high, Moderate

depending to high, Risk

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Study Session 6 Cross-Reference to CFA Institute Assigned Reading #14-Managing Institutional Investor Portfolios

Figure2:FactorsAffectingInvestmentPoliciesof Institutional Investors(Continued)

InstitutionalInvestor Type

Non-Life

Insurance Companies

IPS

Foundations Component

Liquidity is

also relative

to liabilities.

Banks need continuing liquidity for

liabilities and new loans.

Fixed-income Fixed-income portion: portion:

relatively relatively high.

Some hold Some hold Depends

on age of

Liquidity workforce and

retired lives proportion.

a percentage a percentage

of annual of annual distribution distribution high.

amount as a amount as a

cash reserve, cash reserve Surplus Surplus

segment: nil segment: nil.

Time horizon tends to

be short to

intermediate because

of mostly short-term liabilities.

Long, usually infinite.

Getting shorter.

Must meet

regulatory

requirements for liquidity,

reserves, and

Moderate,

Prudent especially but

investor rule on the state increasing/

typically level/prudent prudent pledging.

applies investor rule, investor rule Usually with

The financial

status of the firm; the

management

of investment

risk and liquidity requirements influence

IPS.

Varies from bank to bank.

May need to

use securities

portfolio as

diversification tool and/or

to provide

liquidity.

Must distinguish between strategies for the fixed-

income

segment and the surplus

Unique time horizon, ethical

Needs and company concerns

balance sheet may restrict due to

affect policy certain

securities funds.

common

nature of

*The prudent investor rule requires a fiduciary to “prudently” invest trust assets as if they were his own

based on the knowledge the fiduciary has at the time and considering only the needs of the trust’s

beneficiaries.

The prudent expert rule requires that the fiduciary manage the portfolio with the care, skill, prudence,

and diligence, under the circumstances then prevailing, that a prudent investor would use It extends the

Trang 32

diversificationbecausebothjoband pension are

linked to health

of employer.

Investment risk.

Regular fundingobligation.Early

retirement and other options can increaseliquidityrequirements.

Highly regulated

bygovernments.

Extra resources

needed to fulfill duediligence

Possible pension income Ability

to support stock with some investment in

company stock.

No investment

risk Stable

retirement income.

Defined Benefit

Usually legallyrequiredto have

an IPS that addresses how theplanwillhelpparticipants meet

theirobjectivesand constraints (e.g., types

and number

of investment alternatives,

advice).

Own allpersonalcontributions No financial Once vested, liability other

own all sponsor than matching contributions provisions No Assets easily investment risk.

transferred to

another plan.

Candiversifyportfolioto suit

needs Lowers taxable income.

Investment risk Must

monitor and make necessary

reallocation decisions.

Restrictedwithdrawal of funds.

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LOS14.C

Underfunded plans indicatealiability funding shortfall Although theremaybea

willingnesstotakegreaterinvestment risk,the underfundedstatusdictatesadecreased

abilitytotake risk

Sponsor financialstatuscanbe indicated by the sponsor’s balance sheet Profitability

canbe indicated by thesponsor’scurrentorproforma financials.Lowerdebtratiosand

highercurrentand expected profitability indicate better capability of meeting pension

liabilitiesand, therefore,implygreaterabilitytotake risk The oppositeisalsotrue.

Commonrisk exposureismeasured by the correlation between the firm’s operating

characteristics and pensionasset returns.The higher the correlation between firm’s

operations and pensionasset returns,the lower the risk tolerance The oppositeisalso

true.

Plan features offer participants the option of either retiring earlyorreceivinglump-sum

paymentsfrom theirretirementbenefits Plansthatoffer earlyretirementorlump-sum

paymentsessentiallydecrease thetimehorizonof theretirementliabilityandincrease

the liquidity requirements of the plan.Therefore,the abilitytoassumeriskisdecreased

Workforce characteristics relatetotheageof theworkforce and theratioofactivelives

toretired lives.Ingeneral, the younger theworkforce,thegreatertheratioofactiveto

retired lives will be Thisincreasesthe abilitytotake risk when managing pensionassets.

The oppositeisalsotrue.

LOSI4.d

IPSfor Defined-Benefit Plan

Return:Minimumreturnrequirementisdetermined by actuarialrate.If liquidity needs

arelow and workers young,use acapital gainsfocus;for high-liquidity needs and older

workers, usean incomefocus(durationmatching) Also consider the number ofretirees

the planmust support.

Risk tolerance: Dependsonsurplus,ageofworkforce, time horizon,and company

balance sheet.Forexample,asurplus indicatesahigher risk tolerance

Liquidity: Consider theageof workforce and retired lives population.Income is

requiredto meet payments to retirees,but contributionsareavailablefor longer-term

investments

Timehorizon: Sameasfor liquidity Inaddition,the horizonislong if the planisa

goingconcernbut short ifit isaterminatingplan

Taxes: Usuallytax exempt.

Legal/regulatory:ERISAand the prudentexpertrule apply The planmustbe managed

for the sole benefit of plan participants

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Uniquecircumstances:Could include insufficientresources toperform due diligenceon

complexinvestments,special financialconcernsrelatedtothesponsorfirmorthefund,

socially responsibleinvestingrequirements,et cetera.

LOS14.e

Iftheperformanceof theplanassetsand firm operationsarehighly correlated:

• Whenpensionassetsare generatinghighreturnswithhighoperatingprofits,the

probability of the firm havingtomakeacontributionislow Ifacontributionisnecessary,theamountwill be low The abilitytomakecontributions ishigh when

theplanisfullyfundedoroverfunded.Therefore,the fundisbetter ableto meet

benefitpayments,whichpositivelyimpactsfirmvaluationdueto alowerednegativepensionexpense

• When pensionassets aregenerating lowreturnswith low operating profits, theprobability of the firm havingtomakeapensioncontribution ishigh The firm’sabilitytomakecontributionsislowatthesame timethat theplanisunderfunded

Anunderfundedstatus meansthatthereis adecreased abilityto meet retirement

payments,which negativelyimpactsfirm valuation duetoincreasedpensionexpense

LOS I4.f

Inadefined-contribution plan, the plan employer doesnotestablish theinvestment

goalsandconstraints;rather,the employeedecides herownrisk andreturnobjectives

Therefore,theemployeebears the riskof theinvestmentresults Consequently,theinvestmentpolicystatement (IPS)foradefined-contribution plan describes the

investmentalternatives availabletothe planparticipants.ThisIPSbecomesadocument

of governing principles instead ofanIPSforanindividual.Someof theissuesaddressed

in the IPSwouldbe:

• Makingadistinction betweentheresponsibilitiesof theplanparticipants, thefund

managers,and the plansponsor

• Providing descriptions of theinvestmentalternatives availableto the plan

participants

• Providingcriteriafor monitoringand evaluationof theperformanceof theinvestmentchoices

• Providingcriteriaforselection,termination,and replacement ofinvestmentchoices

• Establishing effectivecommunicationbetween thefundmanagers,plan participants,

and theplansponsor

LOS14.g

Acash balance planis adefined-benefit planthatdefinesthe benefit intermsofan

accountbalance,whichthebeneficiarycantakeas anannuityat retirement or as alump

sum torollintoanother plan.Inatypical cash balance plan,aparticipant’saccountis

credited eachyearwithapaycredit andaninterestcredit Thepaycreditistypically

based upon the beneficiary’sage,salary, and/orlengthofemployment,and theinterest

creditisbaseduponabenchmarksuchasU.S Treasuries Rather than anactualaccountwithabalance, thecashbalance isapaperbalance only andrepresents afuture liabilityfor thecompany

Anemployeestockownership plan(ESOP) is a typeofdefined-contributionbenefitplanthat allows employeestopurchase thecompanystock The purchasecanbe with before-

orafter-tax dollars andthefinal balanceinthe beneficiary’saccountreflectsthe increase

in thevalueof the firm’s stockaswellascontributions during employment

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LOS 14.h

Foundations

AnnualSpendingRequirement

Typeof

Foundation Description Purpose SourceofFunds

Grants to public groups

Company

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