Choosing between Asset-Liability Management and Asset Only approaches
In Level 3's Institutional IPS readings, the CFA Institute addresses the various types of institutional investors along with their similarities and differences. That discussion centers primarily on their RR-TTLLU IPS constraints and the ability of each institution to take on risk given those factors.
Whatever their differences, one common thread shared across all of these institutions is that the most important part of determining their risk tolerance is the relative importance of funding their liabilities.
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) on the other hand, 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.
Most institutions use ALM, at least in some capacity—and it is vital for banks, insurance companies, and defined benefit pension plans. Thus the exam focuses most of its attention on the nuances of ALM rather than AO (which you can treat as the "default" mode for individuals).
Choosing between an ALM or AO framework
In our full level 3 study notes we cover the detailed ALM framework with respect to defined pension plans (the most likely to be tested area) as well as within each type of institution plus relate it explicitly to its broader discussion within the fixed income section.
While we like to save some of the good stuff for our paying clients :) here are some of the key factors you should be aware of if you get a Level 3 exam question askng you to identify whether an institution should employ ALM or AO.
Basically, an institutional investor (such as a bank, DB pension plan, or insurance company) would choose ALM over AO if:
- They have below average risk tolerance
- There are high penalties for failing to meet liabilities (e.g. a pension not paying the retiree)
- When the portfolio risk has a direct impact on the investor’s ability to take risk elsewhere
The last three reasons for using ALM over AO are tied specifically to interest rates and fixed income investments. Namely ALM is more attractive when:
- There are legal or regulatory requirements in place for holding fixed income
- Liabilities are highly sensitive to interest rates
- There are tax incentives that make fixed income holdings much more attractive