CFA LV1 2025 Portfolio Management PDF

© CFA Institute. For c andidate use only. Not for distribution. 138 Learning Module 3 Portfolio Management: An Overview Globally, many wealth management firms and asset managers target high-net-worth...

© CFA Institute. For c andidate use only. Not for distribution. 138 Learning Module 3 Portfolio Management: An Overview Globally, many wealth management firms and asset managers target high-net-worth investors. These clients often require more customized investment solutions alongside tax and estate planning services. Institutional Investors Institutional investors primarily include defined benefit pension plans, endowments and foundations, banks, insurance companies, investment companies, and sovereign wealth funds. Each of these has unique goals, asset allocation preferences, and invest- ment strategy needs. Defined Benefit Pension Plans Pension plans are typically categorized as either defined contribution (DC) or defined benefit (DB). We previously described DC plans, which relate to individual investors. Defined benefit pension plans (DB plans) are company-sponsored plans that offer employees a predefined benefit on retirement. The future benefit is defined because the DB plan requires the plan sponsor to specify the obligation stated in terms of the retirement income benefits owed to participants. Generally, employers are responsible for the contributions made to a DB plan and bear the risk associated with adequately funding the benefits offered to employees. Plans are committed to paying pensions to members, and the assets of these plans are there to fund those payments. Plan managers need to ensure that sufficient assets will be available to pay pension benefits as they come due. The plan may have an indefinitely long time horizon if new plan members are being admitted or a finite time horizon if the plan has been closed to new members. In some cases, the plan managers attempt to match the fund’s assets to its liabilities by, for example, investing in bonds that will produce cash flows corresponding to expected future pension payments. There may be many different investment philosophies for pension plans, depending on funded status and other variables. An ongoing trend is that plan sponsors increasingly favor DC plans over DB plans because DC plans typically have lower costs/risk to the company. As a result, DB plans have been losing market share of pension assets to DC plans. Nevertheless, DB plans, both public and private, remain sizable sources of investment funds for asset managers. As Exhibit 12 shows, global pension assets totaled more than US$41 trillion by the end of 2017. The United States, United Kingdom, and Japan represent the three largest pension markets in the world, comprising more than 76% of global pension assets. Exhibit 12: Global Pension Assets (as of year-end 2017) Country/Region Total Assets (US$ billions) United States 25,411 United Kingdom 3,111 Japan 3,054 Australia 1,924 Canada 1,769 Netherlands 1,598 Switzerland 906 South Korea 725 Germany 472 Brazil 269 South Africa 258  © CFA Institute. For c andidate use only. Not for distribution. Types of Investors 139 Country/Region Total Assets (US$ billions) Finland 233 Malaysia 227 Chile 205 Mexico 177 Italy 184 France 167 Chinese mainland 177 Hong Kong SAR 164 Ireland 157 India 120 Spain 44 Total 41,355 Note: Column does not sum precisely because of rounding. Source: Willis Towers Watson. By geography, the United States and Australia have a higher proportion of pension assets in DC plans, whereas Canada, Japan, the Netherlands, and the United Kingdom remain weighted toward DB plans (see Exhibit 13). Exhibit 13: Pension Plan Type by Geography P7 52% 48% United States 40% 60% UK 82% 18% Switzerland 0% Netherlands 94% 6% Japan 96% 4% Canada 95% 5% Australia 13% 87% DB DC Notes: “P7” represents the combination of the seven countries listed. No data were available for Switzerland for this study. Sources: Willis Towers Watson and secondary sources. Endowments and Foundations Endowments are funds of non-profit institutions that help the institutions provide designated services. In contrast, foundations are grant-making entities. Endowments and foundations collectively represent an estimated US$1.6 trillion in assets in the United States, which is the primary market for endowments and foundations. Endowments and foundations typically allocate a sizable portion of their assets in alternative investments (Exhibit 14). This large allocation to alternative investments primarily reflects the typically long time horizon of endowments and foundations, as well as the popularity of endowment-specific asset allocation models developed by Yale University’s endowment managers David Swensen and Dean Takahashi.  © CFA Institute. For c andidate use only. Not for distribution. 140 Learning Module 3 Portfolio Management: An Overview Exhibit 14: Asset Allocations for US College and University Endowments and Affiliated Foundations (as of 30 June 2017, dollar weighted) Asset Class Percentage Allocation Domestic equity 15 Fixed income 7 Foreign equity 20 Alternatives 54 Cash 4 Source: National Association of College and University Budget Officers and Commonfund Institute. A typical investment objective of an endowment or a foundation is to maintain the real (inflation-adjusted) capital value of the fund while generating income to fund the objectives of the institution. Most foundations and endowments are established with the intent of having perpetual lives. Exhibit 15 describes the Yale University endow- ment’s approach to balancing short-term spending needs with ensuring that future generations also benefit from the endowment, and it also shows the Wellcome Trust’s approach. The investment approach undertaken considers the objectives and constraints of the institution (for example, no tobacco investments for a medical endowment). Exhibit 15: Spending Rules The following examples of spending rules are excerpts from the Yale University endowment (in the United States) and from the Wellcome Trust (in the United Kingdom). Yale University Endowment The spending rule is at the heart of fiscal discipline for an endowed insti- tution. Spending policies define an institution’s compromise between the conflicting goals of providing substantial support for current operations and preserving purchasing power of Endowment assets. The spending rule must be clearly defined and consistently applied for the concept of budget balance to have meaning. The Endowment spending policy, which allocates Endowment earnings to operations, balances the competing objectives of providing a stable flow of income to the operating budget and protecting the real value of the Endowment over time. The spending policy manages the trade-of between these two objectives by combining a long-term spending rate target with a smoothing rule, which adjusts spending in any given year gradually in response to changes in Endowment market value. The target spending rate approved by the Yale Corporation currently stands at 5.25%. According to the smoothing rule, Endowment spending in a given year sums to 80% of the previous year’s spending and 20% of the targeted long-term spending rate applied to the fiscal year-end market value two years prior. Source: 2017 Yale Endowment Annual Report (p.18) [http://investments.yale.edu/endowment-update/]  © CFA Institute. For c andidate use only. Not for distribution. Types of Investors 141 Wellcome Trust Our overall investment objective is to generate 4.5% percent real return over the long term. This is to provide for real increases in annual expenditure while reserv- ing the Trust’s capital base to balance the needs of current and future beneficiaries. We use this absolute return strategy because it aligns asset allocation with funding requirements and provides a competitive framework in which to judge individual investments. Source: Wellcome Trust website (https://wellcome.ac.uk/about-us/investments) Banks Banks are financial intermediaries that accept deposits and lend money. Banks often have excess reserves that are invested in relatively conservative and very short-duration fixed-income investments, with a goal of earning an excess return above interest obli- gations due to depositors. Liquidity is a paramount concern for banks that stand ready to meet depositor requests for withdrawals. Many large banks have asset management divisions that offer retail and institutional products to their clients. Insurance Companies Insurance companies receive premiums for the policies they write, and they need to invest these premiums in a manner that will allow them to pay claims. Insurance companies can be segmented into two broad types: life insurers and property and casualty (P&C) insurers. Insurance premiums from policyholders com- prise an insurance company’s general account. To pay claims to policyholders, regu- latory guidelines maintain that an insurance company’s general account is typically invested conservatively in a diverse allocation of fixed-income securities. General account portfolio allocations differ among life, P&C, and other specialty insurers (e.g., reinsurance) because of both the varying duration of liabilities and the unique liquidity considerations across insurance type.10 In contrast to the general account, an insurer’s surplus account is the difference between its assets and liabilities. An insurer’s surplus account typically targets a higher return than the general account and thus often invests in less-conservative asset classes, such as public and private equities, real estate, infrastructure, and hedge funds. Many insurance companies have in-house portfolio management teams responsible for managing general account assets. Some insurance companies offer portfolio man- agement services and products in addition to their insurance offerings. An increasing trend among insurers (particularly in the United States) is outsourcing some of the portfolio management responsibilities—primarily sophisticated alternative asset classes—to unaffiliated asset managers. Several insurers manage investments for third-party clients, often through separately branded subsidiaries. Sovereign Wealth Funds Sovereign wealth funds (SWFs) are state-owned investment funds or entities that invest in financial or real assets. SWFs do not typically manage specific liability obligations, such as pensions, and have varying investment horizons and objectives based on funding the government’s goals (for example, budget stabilization or future 10 For example, life insurers tend to invest in longer-term assets (e.g., 30-year government and corporate bonds) relative to P&C insurers because of the longer-term nature of their liabilities.  © CFA Institute. For c andidate use only. Not for distribution. 142 Learning Module 3 Portfolio Management: An Overview development projects). SWF assets more than doubled from 2007 to March 2018, totaling more than US$7.6 trillion.11Exhibit 16 lists the 10 largest SWFs in the world. The largest SWFs tend to be concentrated in Asia and in natural resource-rich places. Exhibit 16: Largest Sovereign Wealth Funds (as of August 2018, in US$ billions) Place Sovereign Wealth Fund (Inception Year) Assets Norway Government Pension Fund—Global (1990) 1,058 Chinese Mainland China Investment Corporation (2007) 941 UAE – Abu Dhabi Abu Dhabi Investment Authority (1976) 683 Kuwait Kuwait Investment Authority (1953) 592 Hong Kong SAR Hong Kong Monetary Authority Investment 523 Portfolio (1993) Saudi Arabia SAMA Foreign Holdings (1952) 516 Chinese Mainland SAFE Investment Company (1997) 441 Singapore Government of Singapore Investment 390 Authority (1981) Singapore Temasek Holdings (1974) 375 Saudi Arabia Public Investment Fund (2008) 360 Total SWF Assets under 8,109 Management Source: SWF Institute (www.swfinstitute.org). Investment needs vary across client groups. With some groups of clients, general- izations are possible. In other groups, needs vary by client. Exhibit 17 summarizes needs within each group. Exhibit 17: Summary of Investment Needs by Client Type Client Time Horizon Risk Tolerance Income Needs Liquidity Needs Individual investors Varies by individual Varies by individual Varies by individual Varies by individual Defined benefit pension Typically long term Typically quite high High for mature funds; Varies by maturity of plans low for growing funds the plan Endowments and Very long term Typically high To meet spending Typically quite low foundations commitments Banks Short term Quite low To pay interest on High to meet repayment deposits and opera- of deposits tional expenses Insurance companies Short term for property Typically quite low Typically low High to meet claims and casualty; long term for life insurance companies 11 SWFI, “Sovereign Wealth Fund Rankings” (https://www.swfinstitute.org/sovereign-wealth-fund-rankings/ ; retrieved October 2018).