Managing Institutional Portfolios - Cram Guide

IPS for Pension Fund: The required return calculation is usually a mandatory minimum actuarial rate plus inflation and management fees. This excess return requirement is acceptable only if a plan is fully funded or has a surplus, but may not be realistic if the plan is underfunded and cannot take on more risk to drive returns higher.

Pension fund Risk; Ability is average to below average and depends on: Plan surplus (+), financial status/profitability of firm (+), correlation between company performance and pension fund and the company (-), liquidity features in the plan (-, lump-sum agreements, amount of sponsor contributions), and workforce characteristics (retirement age and ratio of active-to-retired workers). Time is infinite unless shutting down, can have sub-portfolios for retired/active.

Foundations & Endowments: Foundations are grant-making entities, usually begun through a wealthy contributor (e.g. the Gates Foundation). Endowments are long-term funds set aside to support non-profits (e.g. a college endowment)

Life Insurance & Non-life insurance: Return equal to actuarial minimum return. Life insurance have conservative to below-avg risk tolerance. Life insurance companies face uncertainty about timing of payment but amount is defined. Non-life (P&C) insurers have greater uncertainty about both amount and timing of payment. Duration for life insurance usually 20-40 years, non-life much shorter (b/c duration of liabilities shorter). ALM techniques commonly employed to manage risk/liquidity. Unique includes geography.

Banks: Most conservative of the institutions, will use ALM to hedge. Return goal is to earn a positive interest rate spread above cost of funds. Time horizon is matched by the liabilities and is usually less than 10 years. Banks face ongoing liquidity needs to meet withdrawals, loans, etc. Highly regulated with capital requirements. Unique: Geographic concentration, type of loan, can’t divest.

ALM vs. AO:
Institutions with fewer constraints on their liabilities can employ an asset only (AO) approach. With AO, the goal is to maximize total return, and the market risk of any liabilities is not considered. Asset Liability management (ALM) explicitly considers the risks of liabilities and seeks to construct a portfolio that minimizes chances of shortfall risk. ALM does this by selecting assets that have a high correlation with liabilities. If liabilities increase, assets should too, thereby ensuring there is always sufficient cash on hand. DB Pension funds, insurance companies, and banks often use ALM. Foundations, Endowments, and DC plans do not. In a pension fund, ALM has three buckets to match liabilities depending on active or retired. Inactive participants are hedged with nominal bonds (sometimes inflation-indexed), the same for the already accrued benefits of active lives, and future benefits hedged with equities.