overview

1. overview MFIN5600 Institutional wealth management

2. Institutional investors: who are they?

3. Institutional investors: who are they? • Mostly tax-free institutions: pension funds, endowments, foundations • They can manage their assets in house, or outsource to professional portfolio managers

4. Decision making process: planning 1. Planning • Establish investment objectives, risk tolerance, and constraints • Put these in the Investment Policy Statement (IPS) • Form capital market expectations and determine the optimal asset allocation • Most plans work with an institutional client consultant: Mercer, Towers Watson, Russell, Aon Hewitt…etc.

5. Decision making process: execution 2. Execution • Passive or active investing? • Outsource management or manage in-house? • Conduct manager searches (with the help of a manager search consultant?)

6. Decision making process: feedback 3. Feedback • Periodic performance evaluation: mostly likely quarterly • Monitoring • Rebalancing (when current asset allocation deviates “substantially” from the target)

7. Decision making process: RECAP • Three stages: • Planning • Execution • Feedback • A little bit more on each stage….

8. Planning: return objectives • Establish a return objective or target • Depends on current and future spending needs • Objective can be an absolute percentage (e.g., 5% per annum), or a relative percentage (CPI + 3%) • Example: Canada Pension Plan Investment Board (CPP IB) • CPI + 4% • An actuarial estimate based on the plan’s liabilities • For pension plans, falling short of the objective consistently would necessitate: • An increase in contribution, and/or • A cut in pension benefits

9. Planning: Risk objectives • If there are no free lunch plans, then risk and return are related • How to measure risk? • Variance/standard deviation • Downside risk, value-at-risk (VaR), conditional VaR • Tracking error • Investor’s ability to take risk • Current and future spending needs (e.g., age of the work force) • Affects the plan sponsor’s operating budget, if there is a funding deficit

10. Planning: iPS • Investment Policy Statement (IPS) • Required by law in most jurisdictions • In Canada, more commonly referred to as the Statement of Investment Policies and Procedures (SIP&P) • Outlines objectives, constraints, benchmarks for performance, manager requirements for reporting…etc. • Most start with a general objective: “to maximize return without undue risk of loss” • Manager has to ensure that all future investment decisions are consistent with outlined objectives and constraints. When necessary and with board (Directors or Trustees) approval, the IPS can be updated (e.g., to add a previously disallowed asset class)

11. Planning: Investment Constraints • What asset classes and strategies are allowed • Are short positions allowed? • Are private equity investments allowed? • Limits on allocation to certain assets? • Responsible investing?

12. Planning: responsible investing (RI) • An investment constraint • Environmental, social, and corporate governance (ESG) factors for screening investments • Can be viewed as a risk management tool • Positive screens: industries fund wants to invest in, employment standards, sustainability • Negative screens: “sin” stocks, human rights violation, nuclear energy • Major Canadian pension plans are signatories of UN’s Principles of Responsible Investment (PRI) • Implementation is a separate issue • Plans are slow to include SRI policy in their IPS (larger plans taking lead) • Impact of RI screens on investment risk and return – empirical evidence is mixed

13. Planning: capital market expectations • In order to determine the optimal asset allocation, need to have all the inputs • Expected returns, variances, covariances • The inputs are usually medium- to long-term forecasts for each asset class • Depends on how frequently the plan revisits the optimal allocation • Typically rely on historical return distributions, with some adjustments based on macroeconomic forecasts for the planning horizon

14. Planning: asset allocation • Strategic asset allocation • A optimized long-term asset allocation with specific return and/or risk objectives, tailored for a client • Will change only if long-term market expectations change, and/or changes to client’s objectives and risk profile • Not affected by short-term market fluctuations, as distinct from tactical asset allocation (TAA), which aims to time the market • TAA: an active investment strategy, involves short-term adjustments to portfolio weights based on short-term predictions of relative performance across asset classes

15. Static vs dynamic strategic asset allocation • Static or single period optimization is the simplest • Does not consider links across time periods • Less complex to model and implement • Repeat when there are changes to market expectations and/or investment objectives • Dynamic asset allocation Outcomes in one period directly affect the optimal decision in the following period • Example: If mean reversion exists in stock returns, then stocks are less risky if horizon is long, and optimal allocation to stocks should be higher than otherwise • Example: take into account serial correlations in the variance of returns

16. Planning: Risk budgeting • How should the desired level of risk be allocated amongst various asset classes? • Motivation for including other asset classes in the portfolio, especially after the financial crisis

17. execution: approaches to investing • Passive • Buy and hold a benchmark portfolio • Indexing • Do not respond to changes in market expectations • Active • Holdings differ from benchmark according to portfolio manager’s assessment • Goal is to beat the benchmark (“add value”)

18. Execution: Selection and implementation • Larger funds have internal staff to manage all or parts of the portfolio • Smaller funds (even funds with billions of assets) rely mostly on external portfolio managers • Spring 2012 Ontario government budget - appoints an advisor to develop a framework to consolidate smaller public-sector pension plans in terms of asset management (economy of scale)

19. Digression: the arithmetic of Active management • Sharpe (FAJ 1991) • Sum up all the assets held by professional portfolio managers • The sum resembles the market portfolio • What is the implication for the average alpha of portfolio managers? • Some managers have positive alphas, some have negative • Conclusion: after fees, active investment is a negative sum game

20. Feedback: Performance evaluation • Monitor progress toward goals and measure manager skill • Skill assessment has three main components: • Measurement – rate of return • Appraisal – relative to a benchmark • Attribution – sources of return include asset allocation, sector selection, security selection

21. Feedback: rebalancing • As time passes, actual asset mix will likely deviate from optimal asset mix • Consider the traditional 60/40 portfolio (60% equity, 40% fixed income) • If the stock market generated a higher return than bonds in the past year, then which asset class would be over its target weight in the portfolio? • Selling when there has been a run-up in price and vice versa • Need to determine the frequency and timing of rebalancing

22. current landscape: global Pension assets • Towers Watson Global Pension Asset Study 2013

23. Current landscape: individual plan assets • Largest plan: Global • Government Pension Investment Fund of Japan (GPIF) – US $1,108.9 billion (2012 Q3) • Largest plan: North America • California Public Employee Retirement System (CALPERS) – US $259.3 billion (2013 Q2) • Largest plan: Canada • Canada Pension Plan Investment Board (CPPIB) – Cdn $183.3 billion (2013 Q1)

24. Case study: CPPIB • Created in 1997; 18 million plan members • Plan was deemed unsustainable due to changing demographics and increased life expectancy • Contribution rate was increased to 4.95% for both employers and employees (i.e., 9.9% total) in 2003

25. Case study: CPPIB • Current asset allocation • By geographical region and by asset class

26. Case study: CPPIB • Reference portfolio • A “low-cost, low complexity portfolio of public market investments” that is deemed sufficient to generate the target return (that would make the CPP sustainable at the current contribution rate for the long term ~ 75 years) • A passive portfolio or benchmark for gauging the performance of the fund

27. Case study: CPpib • Reference portfolio introduced in 2006, implemented in 2007. • Objective of the IB is to create value-added investment returns ≥ that of the reference portfolio • Performance: