Managing Institutional Investor Portfolios －LO policy, investment

cfaedu

CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 5: Portfolio Management for Institutional Investors
Reading 21: Managing Institutional Investor Portfolios
LOS f: Formulate an investment policy statement for a defined-contribution plan.

cfaedu

Which of the following statements would be appropriate for a participant-directed defined contribution plan?

A) Neither are appropriate.

B) Both are appropriate.

C) The plan should be responsible for establishing and revising the interest rate for plan loans to participants.

D) The plan should provide criteria for manager/fund selection, termination and replacement.

---

Answer and Explanation

Instead of stating objectives and constraints (as in defined benefit plans), the purpose of a participant-directed defined contribution investment policy statement is to provide a governing document that describes the investment strategies and alternatives available to plan participants.

cfaedu

Which of the following would be included in an investment policy statement (IPS) for a defined contribution plan?

A) A description of the investment alternatives available to plan participants.

B) Risk objectives.

C) Return requirements.

D) Time horizon.

---

Answer and Explanation

In a defined contribution plan, the plan sponsor does not establish objectives and constraints but rather the plan participants set their own risk and return objectives.

cfaedu

Which of the following statements about defined contribution investment policy statements (IPS) is FALSE?

A) IPS for defined benefit and defined contribution plans are similar in nature.

B) Procedures are established to insure that a myriad of individual investor objectives and constraints can be handled.

C) Plan sponsors should provide education about investing plan funds.

D) Participants in defined contribution plans bear the risk of investment results.

---

Answer and Explanation

Defined contribution plans call for quite a different IPS than do defined benefit plans.

cfaedu

Regarding the Cooper Company pension plan, Manleys best course of action is to:

A) lower the funds equity allocation by selling the Cooper stock.

B) lower the funds equity allocation, but not sell the Cooper stock, as such a large sale would drive the price down.

C) increase the allocation to equities because risk diminishes over time.

D) maintain the current equity allocation, and diversify the bond portfolio by purchasing some Treasury bills.

---

Answer and Explanation

Manleys fiduciary duty is to the beneficiaries of the plan, not the company. While holding the Cooper stock may benefit the shareholders, it is unlikely to benefit the employees. The company stock provides an undiversified position that is correlated with the employees human capital and should be sold. An equity allocation of 70% would be considered high for most pension plans (the average is around 50%), so while diversifying the bond holdings may be a good move, maintaining the equity weighting is not. Some thought could be given to the fact that the plan is underfunded, and that the plan needs growth. In this situation, the plan also needs to protect the existing assets from too much risk so that the underfunding situation is not exacerbated. In this case, reducing the equity weight to an average level and increasing contributions would be the best course of action.

---

Which of the following is the best justification for Crandall Companys futures policy?

A) Futures are used to manage short-term risks, and the fund should be concerned with long-term risks.

B) The use of futures is inconsistent with the Prudent Expert Rule of ERISA.

C) Futures are used mainly for speculative purposes.

D) The pension plan has 60% of its holdings in bonds and plans to continue that allocation.

---

Answer and Explanation

Most futures transactions are used to manage short-term risks and those transactions might not impact long-term risks. Futures are often used to hedge equity holdings, and nothing in the Prudent Expert Rule would prohibit their use under the proper circumstances. The funds bond holdings are irrelevant, as long as there are equity holdings for which futures could be used to hedge risk.

---

Which of Chapmans statements regarding defined-contribution plans is least accurate?

A) The employee makes regular contributions to the fund.

B) The employee bears all of the investment risk.

C) The employer has no financial obligation beyond making contributions to the plan.

D) Benefits are based on formulas relating to employee earnings or length of service.

---

Answer and Explanation

In a defined-contribution plan, the employee typically makes regular contributions to a fund that the company matches according to some formula, such as a percentage of current pay. The employee bears all of the investment risk in a defined contribution plan, and the employer has no financial obligation beyond making regular contributions on behalf of qualifying employees.

---

Regarding its asset classes, Brooke and Associates best course of action is to:

A) separate both venture capital and international stocks as unique asset classes.

B) separate venture capital as a unique asset class, but leave international stocks in the large-company stock class.

C) separate international stocks as a unique asset class, but leave venture capital in the small-company stock class.

D) leave international stocks in the large-company stock class and venture capital in the small-company stock class.

---

Answer and Explanation

It is easier to optimize portfolios using asset classes with different risk characteristics and low correlation with other asset classes. None of the answers are wrong, but separating international stocks and venture capital into their own classes allows for the most precise optimization.

---

Which of the following represents the most appropriate asset allocation for Chapmans pension fund?

A) 60% large-cap stocks, 30% small-cap stocks, 10% foreign stocks.

B) 40% large-cap stocks, 30% high-yield bonds, 20% investment-grade bonds, 10% real estate.

C) 30% large-cap stocks, 45% investment-grade bonds, 25% high-yield bonds.

D) 40% investment-grade bonds, 30% small-cap stocks, 20% large-cap stocks, 10% venture capital.

---

Answer and Explanation

No matter how young the work force, an all-equity investment mix is inappropriate for a pension fund, which is always going to have at least a slight need for liquidity (particularly when the chairman and his lieutenants retire), and must be managed in such a way as to reduce risk. However, the youth of Chapmans work force suggests a 70% weighting in bonds is too conservative. The mix of large-cap stocks and investment-grade and high-yield bonds is attractive, but most of Chapmans employees are both young and well-paid, suggesting they have a high risk tolerance as well as low liquidity demands. The best option is the mix of investment-grade bonds, small-cap and large-cap stocks, and venture capital, the portfolio that probably offers the highest total return. There is nothing wrong with taking some risks in a pension plan, as long as those risks are well considered and suitable given the characteristics of the work force.

cfaedu

Gina Manley, CFA, is a pension fund manager for Brooke and Associates. She manages the pension fund accounts for several small and medium-sized firms.

Company owner Herb Brooke has tasked Manley with reviewing the firms asset-allocation policy. In the past, Brooke and Associates included large-company international stocks and large-company domestic stocks as part of the same asset class because they have similar risk and return properties, even though they have a low (0.4) correlation with each other. Venture capital was included as part of the small-company stock asset class because it has a high correlation (above 0.7) with small-company stocks, even though the risk of venture capital investments is far greater than the risk of small company stocks.

As part of her portfolio management duties, Manley has recently taken over two pension accounts from other fund managers. The first account is the Crandall Company pension account. In reviewing the investment policy for Crandall, she finds a statement that "the fund shall not directly use equity futures, nor shall it hire any outside money manager that uses equity futures as part of its investment strategy in managing the funds assets." 

The second new account Manley has recently acquired is the Cooper Company pension fund. The fund currently has a 70 percent allocation in equities, including 10 percent in Cooper stock, with the rest in bonds. The plan is currently underfunded. Manley believes the funds equity portfolio, including the Cooper stock, will provide an annualized return of 8 percent over the next five years. The funds long-term, investment-grade bonds should provide a 4 percent return. 

Manley is also working with a new client, Chapman Inc., to set up a new pension fund. Manleys discussions so far have been directly with the owner, David Chapman. Manley has laid out for Chapman the advantages and disadvantages of defined-benefit plans and defined-contribution plans. She tells Chapman about the following characteristics of defined-contribution plans:

• The employee makes regular contributions to the fund.

• Benefits are based on formulas relating to employee earnings or length of service.

• The employee bears all of the investment risk.

• The employer has no financial obligation beyond making contributions.

Chapman is comfortable with Brooke and Associates, likes Manleys work, and decides to set up a defined contribution plan. In the process of gathering data, Manley discovers the following information about Chapman Inc.:

•  The company is five years old.
• Most of Chapmans employees graduated from college less than 10 years ago.
• Stock options represent a significant portion of most employees compensation.
• The median annual salary of Chapman employees is $65,000.

David Chapman and two of his vice presidents plan to retire within the next two years.

Which of the following is least likely to be an investment constraint for the Chapman pension fund?

A) Liquidity.

B) Taxes.

C) Investment horizon.

D) Regulations.

---

Answer and Explanation

Given the tax-deferred status of pension funds, taxes are usually not an important issue. Liquidity constraints depend on the age of the work force, and must be given consideration. A pension funds investment horizon also depends on the age of the work force and whether or not the firm is a going concern. While the work force is mostly young, the firm does have some older workers, and thus cannot ignore liquidity and time horizons. Pension funds are regulated under the Employee Retirement Income Security Act (ERISA), and as such are subject to strict rules.