Week 3: Non-Bank Financial Institutions Notes PDF

**Week 3: Non-Bank Financial Institutions** Pension fund and insurance are big institutional investors **Hedge funds:** A collective of investments that is not opened to the public **Investment Funds:** - Mutual funds allow individuals to invest in stock or bonds market on a more efficien...

**Week 3: Non-Bank Financial Institutions** Pension fund and insurance are big institutional investors **Hedge funds:** A collective of investments that is not opened to the public **Investment Funds:** - Mutual funds allow individuals to invest in stock or bonds market on a more efficient basis than they could themselves - Small individuals savings are pooled into larger investment funds: - Lower dealing costs - Greater diversification - Professional management - But investors required to pay a fee for the service annual management charge, 1.0% per year spread between buying and selling prices - Open-ended funds (OEICs; Unit Trusts) - Units created/cancelled to meet demand - Investors buy/sell units with the manager - Typically trade at NAV - Closed-end funds (Investment Trusts) - Fixed amount of shares in issue - After launch, investors buy/sell with each other - May trade at a "discount" or "premium" to NAV - Discounts are most common - Typical funds around the world **Unit Trust and OEICs (opened-ended funds)** - These opened-ended funds are categorized into sectors, e.g. - UK Equity Growth - UK Equity Income - Overseas - Etc. - Specialized as actively managed funds to replicate and attempt to beat an index or sector average - Meanwhile, passive fund to attempt to match the index. - Sufficient enough to earn sufficient returns as they benefit from diversification and lower fees, but will not earn extraordinary returns - Charges around 0.75% for actively managed funds - Most evidence suggests average active managers fail to beat the benchmark - But some studies find persistence in individual fund returns, but not due to managers' skills (Carhart, 1997) - Over 2,000 different unit trust and OEICs available to investors in the UK, investing in 30 sectors Exchange-Traded Funds (ETFs) - Issued by companies issuing shares (*creating shares*) - Backed by range of securities, e.g. - Stocks - Bonds - Commodities - Or combinations of above - Aim to mirror the performance of a particular index such as the S&P 500, or a. sector like healthcare, technology, etc. - Open-ended funds - No. of shares can fluctuate based on demands - Authorized participants like large institutions can create or redeem shares in response to market demand, which helps maintain ETF's liquidity and price stability - Allows investors to buy and sell ETFs shares throughout the trading day at market-determined prices, rather than only at the end-of-day NAV, as with mutual funds - Effectively a hybrid of a tradable stock and index-tracking fund - Combine diversity of a mutual fund with the liquidity and flexibility of stock trading - Offering investors the best of both worlds - Pricing is left up to the marketplace - Prices of ETF shares are determined by the market - Throughout trading day, shares may trade at, or close to the ETFs' NAV (value of underlying assets divided by no. of shares) - Charges range between 0.2% and 0.75% Investment Trusts (Investment Companies) - Set up as companies and floated on the Stock Exchange - Over 400 investment trusts on LSE - Total assets of £80 billion - A type of closed-end funds - Issue fixed no. of shares that trade on the stock exchange - Allows the trusts to manage the assets without worrying about inflows and outflows of from investors' redemptions, easing investment in less liquid or long-term assets - Do not create or redeem shares based on demand - Instead, shares are bought and sold in the open market with prices determined by supply and demand - Run by in-house team of investment managers - Make decisions about which assets to buy or sell within trust's portfolio - Aim to grow the trusts' value by investing in line with its stated goals, e.g. - Capital growth - Income - Or mix of both - Leverage capability - Able to borrow money to enhance investment potential , a strategy known as "gearing" - Allow trusts to invest more capital than it directly holds, potentially boosting returns - But also increase risk exposure as it could increase losses if investment underperformed - Association of Investment Companies (AIC) - A trade body represents investment trust - Listed more than 30 different sectors, including - UK Growth Global - Global Growth Europe - Asia Pacific Infrastructure Mutual Funds - Popular type of collective or pooled investments - Allow investors to combine their money into a single fund that is professionally managed to achieve specific investment goals - In exchange for capital, investors receive shares in the mutual funds, representing a portion of the overall portfolio of assets - These pooled funds are then invested in assets such as - Stocks - Bonds - Etc. - Management and administration - Managed by a team of professional fund managers or an investment firm, who select and manage assets according to fund's objective, e.g. - Growth - Income - Balanced (stability) - BODs appointed by shareholders oversee management to ensure alignment of shareholders' interests - In US and Canada, mutual funds are strictly regulated - US Securities Exchange Commission (SEC) enforces transparency and investors protections via strict rules regarding disclosure, reporting, and management practices - Majority of MF are open-ended funds, but some are closed-end funds - Majority are open-ended, which means they issue new shares to investors and redeem shares when investors want to withdraw capital - Fund size can expand, or contract based on investors' demand, with fund's share price directly linked with its NAV, which is calculated daily - Some are closed-end, which issue fixed no. of shares at inception that are then traded on the stock exchange - Share prices are determined by market and can trade at a premium or a discount to the NAV, depending on investors' demand **Hedge Funds** - Investment funds that attempt to generate positive investment returns based on managers' skills, rather than general market returns - Employ various strategies not normally used in mutual funds such as: - Leverage - Borrow capital to increase position size - Allows investors to take on larger bets, but also increases risks if investment goes against them - Short-selling - Selling shares that they do not own - Frequently used to bet against companies or assets that investors believed that are overvalued or expected for downturn - Involves borrowing shares to sell them now, with the expectation of buying back them later at a lower price - Particularly valuable in falling or volatile markets - Use of derivatives - Derivatives such as options, futures and swaps are often used to hedge risk, speculate or enhance returns - Help funds to take large positions with relatively small initial investment, though they add complexities and risks to the fund - Mostly based offshore in countries, where financial regulation is unstrict (e.g. Cayman) - Offshore locations help funds to avoid some regulatory constraints, and in some cases, offer tax advantages, although managers and investors still face tax liability in their home countries - Fee structure (2 and 20 fee structure) - 2% annual management fee on total assets, regardless of fund performance, to cover operational cost - 20% performance fee on profits for managers - Designed to attract highly-skilled managers and reward successful and reward successful performance - But could also make hedge fund more expensive for invstors - Usually need to be registered with relevant regulators - Would like to minimize their cost and are privately managed to certain investors only - Might specialized in certain sector/industry/institutional - Unlike mutual funds, you have the restrictions to keep your money (investment 2-5 years), unlike mutual funds, where you can buy a share and sell it back later. **Short-Selling** - Sell shares that you do not own (borrowing shares and then sell in the future) - A way of profiting from share prices going down - A common strategy in hedge funds Hedge Fund Strategies - Equity hedge - Objective - Profit from price movements in individual stocks based on the managers' market insights - Approach - Take long positions in stocks that managers believe are undervalued and short positions in stocks that are expected to decline - Allows managers to profit from both rising and falling stock prices, reducing dependency on overall market direction - E.g. - If manager anticipates growth in Company A and a decline in Company B, he buys Company A's stock and short-sell Company B's stock, aiming to generate returns regardless of market trends - Fixed-income arbitrage - Buys underpriced bonds, while shortselling similar (overpriced) issues - Merger arbitrage - Buys shares in takeover targets while shorting shares of the acquirer - Macro - Takes large directional bets on markets, often using leverage to increase returns - Emerging market - Takes positions in emerging market securities (where shorting is often impossible) **Pension Funds** - Investment pool that collects and manage retirement savings for individuals or employees - Providing them with income after retirement - 3 sources of pension income - State pension - A government-provided pension that offers basic income to individuals upon retirement - Amount received based on individual's national insurance contributions or tax payments during working life - Pay-As-You-Go (PAYG) method - Current worker's contributions fund the pensions of current retirees - No pool of savings for future payouts - Instead, each generation pays for previous one - Occupational pension - Known as workplace pension - Established by employers to provide retirement benefits for their employees - Vary in terms of benefits, contribution levels, and payout structures - They are pre-funded - Employer and often the employees contribute to a pension fund during employee's working years - The fund is then invested to grow over time, providing income at retirement - 2 types: - Defined Benefit (DB) - Employer promises set % of pay pension - 1/60^th^ or 1/80^th^ of final salary per year worked - Employee may contribute, but employer bears balance of cost required to pay the promise - Defined Contribution (DC) - Employer and employee contribute to the fund - Employee chooses how to invest the fund - Upon retirement, employee can access the fund as a lump sum or use it to purchase a retirement income (annuity) - Personal pension - Retirement savings plans that individuals can set up independently of their employer - Designed for self-employed individuals or those who wish to supplement their occupational pensions - They are funded, with individuals contributing their own money to the plan - These contributions are then invested in various assets to accumulate a retirement fund Life Assurance - A financial product, where individuals pay premiums to an insurance company, which in return, promises to pay a specified lump sum to policyholders' dependents upon their deaths - Designed to provide financial security and support for beneficiaries in the event of policyholders' passing - Key components - Premium payments - Policyholders pay regular premiums (monthly, quarterly, annually) to maintain life insurance policy - Amount of the premiums vary based on factors such as the insured individual's age, health, and the size of coverage - Lump sum payout - Life insurance company pays a fixed amount (FV of the policy) to beneficiaries upon the policyholder's death - This payout is often used to cover living expenses, debts, or other financial obligations the deceased may have left behind - Fixed liability - Amount of liability (lump sum amount) is predetermined and fixed at the time of policyholder's lifespan - Provides certainty to both insurer and the insured as the amount the insurer must pay is known - Investment strategy - Fund (pool of premiums collected from policyholders) will be invested in assets that are expected to match the liability - Such assets can be: - Government and corporate bonds - Low-risk investments that provide stable returns - Stock and equities - Can offer higher returns over the long term due to volatile markets - Real estate - Can provide both income and appreciation potential - Other assets - May include mutual funds, ETFs, or alternative investments, depending on insurer's strategy and risk appetite - Compared to Pension Funds - Pension funds focuses on a one-time payout, which aim to provide an income stream over an extended period during retirement - Investment strategies and liability management differ significantly due to the nature of the payouts and the timeframes involved - Compared to Health Insurance - Health insurance covers medical expenses incurred during the policyholder's life - Liability structure and payout mechanisms are different in each case Reinsurance - A financial practice in which insurance companies reduce their exposure to significant claims by transferring part of their risk to another insurer, called "reinsurer" - Helps insurers maintain financial stability and manage risk more effectively, especially in cases of large claims or catastrophic events - Reinsurance enhances the primary insurer's capacity to underwrite policies, improves solvency, and allows them to cover larger or risker portfolios than they could alone - Types of reinsurance - Proportional reinsurance - Insurer and reinsurer share premiums and claims in a fixed ratio - E.g. - In a quota share agreement, reinsurer takes on a specified % of each policy's risk - If reinsurer covers 50% of the insurer's risk, they receive 50% of the premiums and pay 50% of the claims - Surplus share reinsurance is another form, where reinsurer only covers losses that exceed a certain threshold, or "retention limit", set by the primary insurer - Allows primary insurer to increase its underwriting capacity and spread risk, while the reinsurer benefits by sharing the insurer's premiums and risks - Non-proportional reinsurance - Reinsurer only steps in when losses exceed a predetermined amount - E.g. - Excess of loss reinsurance covers losses above a certain limit - If a claim exceeds the insurer's retention limit, reinsurer covers the remaining amount, up to the agreed maximum - Stop-loss reinsurance is a variation, where reinsurer covers losses only if they exceed a specified total amount in a given period such as a calendar year - Often used in unexpected large losses and is popular in cases involving catastrophic risks like natural disasters - Retrocessions - A reinsurance of reinsurance where a reinsurer transfers a portion of its own risks to another reinsurer, called a retrocessionaire - Allows reinsurers to limit their exposure further and spread risks across multiple entities, which is particularly useful in markets prone to significant claims, such as those involving natural disasters or life insurance - Helps stabilize the financial market and protect against accumulative losses that could impact the reinsurer's portfolio A screenshot of a graph Description automatically generated **Lloyd**  - An insurance market that provides insurance with various sectors/industries - A marketplace, where customers, brokers, and underwriters meet to discuss requirements - Operates in more than 200 countries and territories worldwide - Provides cover for 8 of the world's top pharmaceutical companies and 52 of the world's top banks **Sovereign Wealth Funds** - Collective funds managed by governments (source of the funds are from surplus cash from the country) - This government funds are managed and invested around the world - UK does not have SWF - Although a country may have cash surplus, but they do not necessarily need to open SWFs - \$3-4 trillion of investments globally  **Microfinance Institutions (MFIs)** - Also known as microbanks/microfunds - Offer financial services to the underprivileged - Began late 1970s as an initiative from NGOs such as Grameen Bank in Bangladesh and the affiliates of ACCION International in Latin America. - Examples: - Fundación para la Promoción y Desarollo de la Microempresa (PRODEM) in Bolivia transformed successfully into a bank - BancoSol (Banco Solidario, A.A. (Bolivia) has captured about 20% of Bolivia's potential market for microfinance - Unit Desai of Bank Rakyat Indonesia counts more than 28 million savers, for only three million borrowers - Opportunity Fund in California offers microloans to small businesses - Bank Rakyat Indonesia - A 70% government-owned bank and operates primarily as a small-scale and microfinance lender with more than 30 million retail banking clients - BRAC - Based in Bangladesh - Provides extensive range of services in the areas of human rights, education, health and economic development - Includes - Grants - Small business loans - Housing assistance - Microsavings services - Kiva Microfunds - A NGO founded in 2005 based in San Francisco - Allow people to lend money via the Internet to low-income business owners and students in over 80 countries Cross-border links between banks and NBFIs - Cross-border bank claims on NBFIs such as investment funds and central counterparties have grown 63% in the last 5 years to \$7.5 trillion in Q1 2020 - Financial links between banks and NBFIs are mainly denominated in US dollars and concentrated in financial centres and large advanced economies, but have also grown in emerging market economies - Vulnerabilities stemming from these growing interconnections were highlighted during the COVID-19 market turmoil, e.g. - In fickle dollar funding from NBFIs and liquidity pressures from high central counterparty margins Find out: What are the mutual funds in UK Difference between open-ended and closed funds Contracts for Difference (CFDs) - A financial agreement between 2 parties, that stipulates that the buyer will pay the seller the difference between the current value of an asset and its value at the time the contract was initiated: - A form of derivative - Cash settled: - usually, the difference between opening and closing price of an asset - Very short-term - Are essentially bets as to whether the price of the underlying asset or security will rise or fall: - those who expect an upwards movement in price will buy the CFD - those who expect a downwards movement will sell the CFD - OTC - Trade on margin - Not traded on major exchanges such as NYSE - Tradeable contract between a client and their broker who will exchange the difference in the initial price of the trade and its value when the trade - Offer benefits and risks of owning a security without owning it - Leverage allows investors to put up only a small percentage of the trade amount with a broker, however this can lead to significant losses due to extreme price volatility - Common types: - Commodity CFD - - Index CFD - Share CFD - FOREX CFD - Cryptocurrency CFD **Margin & Leverage** Margin represent the minimum balance you will need in your account to trade (often expressed as a percentage of the trade value Brokers may offer leverage, and this can differ based on: - Underlying contract - Contract size - Type of clients