Portfolio Management for Institutional Investors (2024)

Refresher Reading

This reading has introduced the subject of managing institutional investor portfolios. The key points made in this reading are as follows:

• The main institutional investor types are pension plans, sovereign wealth funds, endowments, foundations, banks, and insurance companies. Common characteristics among these investors include a large scale (i.e., asset size), a long-term investment horizon, regulatory constraints, a clearly defined governance framework, and principal–agent issues.

• Institutional investors typically codify their mission, investment objectives, and guidelines in an Investment Policy Statement (IPS).

• Four common investment approaches to managing portfolios used by institutional investors are the Norway model, the Endowment model, the Canada model, and the Liability Driven Investing (LDI) model.

• There are two main types of pension plans: defined benefit (DB), in which a plan sponsor commits to paying a specified retirement benefit; and defined contribution (DC), in which contributions are defined but the ultimate retirement benefit is not specified or guaranteed by the plan sponsor.

• Pension plan stakeholders include the employer, employees, retirees, unions, management, the investment committee and/or board of directors, and shareholders.

• The key elements in the calculation of DB plan liabilities are as follows:

  • Service/tenure: The higher the service years, the higher the retirement benefit.

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  • Salary/earnings: The higher the salary over the measurement period, the higher the retirement benefit.

  • Mortality/longevity: The longer the participant’s expected life span, the higher the plan sponsor’s liability.

  • Vesting: Lower turnover results in higher vesting, increasing the plan sponsor’s liabilities.

  • Discount rate: A higher discount rate reduces the present value of the plan sponsor’s liabilities.

• DB plan liquidity needs are driven by the following:

  • Proportion of active employees relative to retirees: More mature pension funds have higher liquidity needs.

  • Age of workforce: Liquidity needs rise as the age of the workforce increases.

  • Plan funded status: If the plan is well funded, the sponsor may reduce contributions, generating a need to hold higher balances of liquid assets to pay benefits.

  • Flexibility: Ability of participants to switch among the sponsor’s plans or to withdraw from the plan.

• Pension plans are subject to significant and evolving regulatory constraints designed to ensure the integrity, adequacy, and sustainability of the pension system. Some incentives, such as tax exemption, are only granted to plans that meet these regulatory requirements. Notable differences in legal, regulatory, and tax considerations can lead to differences in plan design from one country to another or from one group to another (e.g., public plans vs. corporate plans).

• The following risk considerations affect the way DB plans are managed:

  • Plan funded status

  • Sponsor financial strength

  • Interactions between the sponsor’s business and the fund’s investments

  • Plan design

  • Workforce characteristics

• An examination of pension fund asset allocations shows very large differences in average asset allocations by country and within a country despite these plans seeking to achieve similar goals. Such inter- and intra-national differences are driven by many factors, including the differences in legal, regulatory, accounting, and tax constraints; the investment objectives, risk appetites, and investment views of the stakeholders; the liabilities to and demographics of the ultimate beneficiaries; the availability of suitable investment opportunities; and the expected cost of living in retirement.

• The major types of sovereign wealth funds (SWFs) follow:

  • Budget Stabilization funds: Set up to insulate the budget and economy from commodity price volatility and external shocks.

  • Development funds: Established to allocate resources to priority socioeconomic projects, usually infrastructure.

  • Savings funds: Intended to share wealth across generations by transforming non-renewable assets into diversified financial assets.

  • Reserve funds: Intended to reduce the negative carry costs of holding foreign currency reserves or to earn higher return on ample reserves.

  • Pension Reserve funds: Set up to meet identified future outflows with respect to pension-related, contingent-type liabilities on governments’ balance sheets.

• Stakeholders of SWFs include the country’s citizens, the government, external asset managers, and the SWF’s management, investment committee and board of directors.

• Given their mission of intergenerational wealth transfer, SWFs do not generally have clearly defined liabilities, so do not typically pursue asset/liability matching strategies used by other institutional investor types.

• Sovereign wealth funds have differing liquidity needs. Budget stabilization funds require the most liquidity, followed by reserve funds. At the other end of the spectrum are savings funds with low liquidity needs, followed by pension reserve funds.

• The investment objectives of SWFs are often clearly articulated in the legislative instruments that create them. They are often tax free in their home country, though must take foreign taxation into consideration. Given their significant asset sizes and the nature of their stakeholders, SWFs have aimed to increase transparency regarding their investment activities. In this regard, the Santiago Principles are a form of self-regulation.

• The typical asset allocation by SWF type shows budget stabilization funds are invested mainly in bonds and cash given their liquidity needs. Reserve Funds invest in equities and alternatives but maintain a significant allocation of bonds for liquidity. Savings funds and pension reserve funds hold relatively higher allocations of equities and alternatives because of their longer-term liabilities.

• Endowments and foundations typically invest to maintain purchasing power while financing their supporting university (endowments) or making grants (foundations) in perpetuity—based on the notion of intergenerational equity. Endowments and foundations usually have a formal spending policy that determines how much is paid out annually to support their mission. This future stream of payouts represents their liabilities. For endowments, other liability-related factors to be considered when setting investment policy are: 1) the ability to raise additional funds from donors/alumni, 2) the percentage of the university’s operating budget provided by the endowment, and 3) the ability to issue debt.

• Foundations and endowments typically enjoy tax-exempt status and face relatively little regulation compared to other types of institutional investors.

• Foundations face less flexible spending rules compared to endowments; foundations in the US are legally mandated to pay out 5% of their assets annually to maintain tax-exempt status. Endowments and foundations have relatively low liquidity needs. However, foundations have somewhat higher liquidity needs (vs. endowments), because they 1) typically pay out slightly more as a percentage of assets, and 2) finance the entire operating budget of the organization they support.

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• Endowments and foundations typically have a long-term real return objective of about 5% consistent with their spending policies. This real return objective, and a desire to maintain purchasing power, results in endowments and foundations making significant allocations to real assets. In general, endowments and foundations invest heavily in private asset classes and hedge funds and have relatively small allocations to fixed income.

• Banking and insurance companies manage both portfolio assets and institutional liabilities to achieve an extremely high probability that obligations on deposits, guarantees, derivatives, policyholder claims, and other liabilities will be paid in full and on time.

• Banking and insurance companies have perpetual time horizons. Strategically, their goal is to maximize net present value to capital holders; tactically, this may be achieved by liability driven investing (LDI) over intermediate and shorter horizons.

• Financial institutions are highly regulated because of their importance to the non-financial, or real, sectors of the economy. Such institutions are also regulated in order to minimize contagion risk rippling throughout the financial and real sectors.

• The underlying premise of regulation is that an institution’s capital must be adequate to absorb shocks to both asset and liability values. This implies limiting the volatility of value of the institution’s shareholder capital.

• The volatility of shareholder capital can be managed by (a) reducing the price volatility of portfolio investments, loans, and derivatives; (b) lowering the volatility from unexpected shocks to claims, deposits, guarantees, and other liabilities; (c) limiting leverage; and (d) attempting to achieve positive correlation between changes in the value of assets and liabilities.

• Ample liquidity, diversification of portfolio and other assets, high investment quality, transparency, stable funding, duration management, diversification of insurance underwriting risks, and monetary limits on guarantees, funding commitments, and insurance claims are some of the ways management and regulators attempt to achieve low volatility of shareholder capital value.