Managing Institutional Investor Portfolios －LO foundation, investment, insurance, company, policy

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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 j: Formulate an investment policy statement for a foundation, an endowment, an insurance company, and a bank.

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Based on a 9.5 percent return objective, the most appropriate allocation to high yield bonds and small cap equities is likely to be:

A) the same or higher for high yield bonds; the same for small cap stocks.

B) lower for high yield bonds; higher for small cap stocks.

C) zero for high yield bonds; higher for small cap stocks.

D) initially lower for both high yield bonds and small cap stocks and then increased as the endowment increases in value since it will be able to take on more risk at that time.

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Answer and Explanation

Some exposure to high yields is warranted given their favorable risk/return profile versus equities. Somewhere between 5 and 10 percent is probably a reasonable allocation to this asset class. The existing small cap allocation seems reasonable, given the risk/return objective of the fund. However, 15 percent is probably an adequate allocation to this asset class.

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Based on a 9.5 percent return objective, the most appropriate revision to the Foundations intermediate and long-term bond allocation is:

A) the same for intermediate-term bonds; higher for long-term bonds.

B) higher for intermediate-term bonds; higher for long-term bonds.

C) no change for either intermediate or long-term bonds.

D) lower for intermediate-term bonds; higher for long-term bonds.

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Answer and Explanation

Since the time horizon is infinite, it would make sense for more of the bond allocation to be shifted from intermediate into higher-returning long-term bonds.

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With regards to Turner and Davenports comments about the value of international investing:

A) Turner is incorrect; Davenport is incorrect.

B) Turner is correct; Davenport is incorrect.

C) Turner is correct; Davenport is correct.

D) Turner is incorrect; Davenport is correct.

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Answer and Explanation

The comments of both Turner and Davenport are technically correct, although incomplete in terms of an in-depth discussion. The customary arguments for international investing include increased security selection, possible excess returns, and potential risk reduction due to low correlation with the U.S. market. However there are a number of arguments against international investing, including some evidence that correlations are increasing and that they increase when market volatility is highest, thereby diminishing diversification when it is most needed. There have definitely been significant periods of time when international stocks have under-performed the U.S. market. Although transaction costs have been falling, there are still a number of barriers such as legal and accounting differences, tax regulations, lack of liquidity, etc. Finally, it does appear that industry factors now dominate country or regional factors, but country factors still remain important. Using only U.S.-based global companies can expose domestic-only portfolios to significant country risk.

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The trustees want Turner to look at suitable hedge funds. The best alternative for Turner to consider would be a:

A) fundamental long-short hedge fund.

B) quantitative long-short hedge fund.

C) macro hedge fund.

D) fund of funds hedge fund.

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Answer and Explanation

The small size of the Foundation precludes a large allocation to hedge funds, therefore the only reasonable vehicle is a fund of funds.

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Which of the following is the most appropriate return objective for a private foundation that has been established to provide support in perpetuity?

A) The market return plus expected inflation.

B) 5.3 percent of assets plus expected inflation.

C) 8.3 percent of assets plus expected inflation.

D) The long-term treasury bond return plus inflation.

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Answer and Explanation

Private foundations are required to pay out 5 percent of assets annually. Also, foundations set up to provide perpetual support must be concerned with the preservation of capital. Hence, 5.3 percent plus an adjustment for inflation is a useful guideline for quantifying the return objective for a private foundation.

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Which of the following objectives and/or constraints would be found in an investment policy statement (IPS) for a private foundation but NOT necessarily for an endowment?

A) Total return approach.

B) Moderate to high risk tolerance.

C) Set spending rates.

D) Infinite time horizon.

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Answer and Explanation

Both foundation and endowment IPS should include a return objective that specifies a total return approach. Additionally, both foundations and endowments have moderate to high risk tolerance levels and an infinite time horizon. Only private foundations are required to set spending rates.

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Which of the following entities could be subject to unrelated business income tax (UBIT)?

A) Only endowments.

B) Endowments and foundations.

C) Only foundations.

D) Neither endowments nor foundations.

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Answer and Explanation

UBIT must be paid by both endowments and foundations if income is produced that is not substantially related to a foundations/endowments charitable purpose.

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The investment policy statement (IPS) of which of the following entities may include language pertaining to net interest spread?

A) Insurance companies.

B) Endowments.

C) Foundations.

D) Defined benefit plans.

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Answer and Explanation

Net interest spread is the difference between interest earned and interest credited to policyholders. Therefore, net interest spread may be talked about in the return objectives of an insurance companys IPS.

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World Wide Telecom (WWT), a troubled internet service provider recently filed Chapter 11 bankruptcy after seven unsuccessful years of operations. It was a plan sponsor in WWT Pension Plan for the benefit of its employees. The following information was available at the time of its bankruptcy filing:

• Employees: 500

• Plan assets: $15 million

• Plan liabilities: $19 million

• Average age of workforce: 30

• 1% of plan assets are being paid out to retirees and no more participants are expected to retire over the next five years.

• Due to the companys financial condition, the plan was under-funded.

• The duration of the plan liabilities is 25 years.

• Inflation is expected to be approximately 1% over the next five years.

The bankruptcy trustee appointed Eric Geecu, CFA, as the portfolio manager overseeing the WWT Pension Plan to develop guidelines for its investment policy statement and the ultimate distribution of the proceeds of the plan upon fully funded status. Geecu believes that fully funded status could be achieved within the next five years, assuming the plan earns an expected rate of return in excess of its plan liabilities. The plan liabilities are expected to increase at the rate of inflation.

In developing an investment policy statement (IPS) for WWT Pension Plan, which constraints should Geecu consider?

A) A short time horizon, low liquidity needs, with assets managed according to the "prudent expert" rule.

B) A long time horizon, unique circumstances associated with the Chapter 11 bankruptcy, with no current taxes to be considered for the pension plan.

C) The pension plan is governed under ERISA, unique circumstances that the plan cannot provide any funds to meet the plan's underfunded status, and a long time horizon.

D) High liquidation needs, long time horizon, with no taxes to be currently considered for the plan.

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Answer and Explanation

Time horizon The time horizon for this plan is short. Since the plan sponsor, WWT, is currently in bankruptcy and would not be considered a going concern, it cannot provide any funds to minimize the plan deficit. Since there is only a 5-year time horizon for the plan coupled with the uncertainty on the disposition of available funds in five years, the primary goal of this plan is on capital preservation with a secondary focus on income and a third goal of some growth over the time horizon. Five years is a short time frame to achieve these goals. Any IPS developed must consider capital preservation first and then consider a total return approach to preserve the plan from the effects of inflation.

Liquidity The liquidity needs of this portfolio are low primarily because only 1% of the plan assets are currently being paid out and no more employees are expected to retire over the next five years. The average age of the workforce is 30 and young and will not require any distributions until the expected termination upon its fully funded status. Therefore, the plan only has to provide for its current retirees at a rate of 1% per year.

Laws and regulations This pension plan is governed by ERISA and must adhere to the prudent expert rule. As such, diversification is necessary to minimize the risk of large losses to the plan and capital preservation.

Taxes There are none to be considered for the pension plan. However, upon the distribution of the plan assets after five years, there could be a tax impact on the plan participants. Tax counsel is advised here for the plan and its participants to also do some tax planning for the ultimate distribution of the proceeds of the plan in five years.

Unique circumstances WWT, the plan sponsor, is in a Chapter 11 bankruptcy filing and, therefore, cannot provide any funds to meet the plans underfunded status. The plan must also consider the administration of the distribution of the proceeds of the plan after five years to its plan participants. Should the underfunded status remain (assuming a higher than expected level of benefits are paid out to retirees or the expected rate of return does not meet the level of the plan liabilities) special policies and procedures may need to be considered at the time of the distribution of the plan assets.

Time horizon The time horizon for this plan is short. Since the plan sponsor, WWT, is currently in bankruptcy and would not be considered a going concern, it cannot provide any funds to minimize the plan deficit. Since there is only a 5-year time horizon for the plan coupled with the uncertainty on the disposition of available funds in five years, the primary goal of this plan is on capital preservation with a secondary focus on income and a third goal of some growth over the time horizon. Five years is a short time frame to achieve these goals. Any IPS developed must consider capital preservation first and then consider a total return approach to preserve the plan from the effects of inflation.

Liquidity The liquidity needs of this portfolio are low primarily because only 1% of the plan assets are currently being paid out and no more employees are expected to retire over the next five years. The average age of the workforce is 30 and young and will not require any distributions until the expected termination upon its fully funded status. Therefore, the plan only has to provide for its current retirees at a rate of 1% per year.

Laws and regulations This pension plan is governed by ERISA and must adhere to the prudent expert rule. As such, diversification is necessary to minimize the risk of large losses to the plan and capital preservation.

Taxes There are none to be considered for the pension plan. However, upon the distribution of the plan assets after five years, there could be a tax impact on the plan participants. Tax counsel is advised here for the plan and its participants to also do some tax planning for the ultimate distribution of the proceeds of the plan in five years.

Unique circumstances WWT, the plan sponsor, is in a Chapter 11 bankruptcy filing and, therefore, cannot provide any funds to meet the plans underfunded status. The plan must also consider the administration of the distribution of the proceeds of the plan after five years to its plan participants. Should the underfunded status remain (assuming a higher than expected level of benefits are paid out to retirees or the expected rate of return does not meet the level of the plan liabilities) special policies and procedures may need to be considered at the time of the distribution of the plan assets.

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In developing an IPS for WWT Pension Plan, what must Geecu consider with respect to the return objective and risk tolerance for the plan?

A) Return requirement = 7.89%, risk tolerance = moderate to high.

B) Return requirement = 7.33%, risk tolerance = low to average.

C) Return requirement = 5.96%, risk tolerance = high.

D) Return requirement = 6.84%, risk tolerance = low or below average.

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Answer and Explanation

Return requirement The plan must consider the preservation of capital as its primary objective over the 5-year time horizon. The plan should focus on a goal of obtaining an expected rate of return of 6.84% to eliminate the plan deficit of $4 million (plan asset of $15 million less plan liabilities of $19 million) and preserve the plan from the effects of inflation.

• PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84%
• Rate of return to achieve fully funded status = 4.84%
• Plus: benefits paid out to retirees = 1.00%
• Plus: expected inflation rate = 1.00%
• Equals the return requirement = 6.84%

Since the bankruptcy court has mandated that the plan liabilities will be held constant at $19 million, the plan assets could be invested at a required rate to achieve fully funded status in five years. Thus, the computation to achieve the rate of return is: (Future Value Present Value) (1/term) or using a financial calculator =4.84%. The result of this calculation is 4.84 percent. Additionally, we must also include the benefits currently paid out to retirees of 1 percent plus the expected inflation rate of 1 percent to arrive at the return requirement of 6.84 percent.

This return requirement allows the plan to close the plan deficit while also providing retirement benefits to its retirees and preserving the capital from the effects of inflation.

Risk Tolerance The risk tolerance for the pension plan is low or below average. The primary objective of the plan is to preserve the plan assets and protect it from the effects of inflation with the ultimate goal of achieving a fully funded status in five years. Given the short time horizon of five years and its current underfunded status and the inability of its plan sponsor to commit any fund to the plan (due to bankruptcy), the plan cannot be subjected to any unexpected levels of market risk. Furthermore, it is currently paying out benefits to retirees, so it must have the liquidity to provide such benefits.

Return requirement The plan must consider the preservation of capital as its primary objective over the 5-year time horizon. The plan should focus on a goal of obtaining an expected rate of return of 6.84% to eliminate the plan deficit of $4 million (plan asset of $15 million less plan liabilities of $19 million) and preserve the plan from the effects of inflation.

• PV= -15 FV=19 N=5 PMT=0 CPT I/Y = 4.84%
• Rate of return to achieve fully funded status = 4.84%
• Plus: benefits paid out to retirees = 1.00%
• Plus: expected inflation rate = 1.00%
• Equals the return requirement = 6.84%

Since the bankruptcy court has mandated that the plan liabilities will be held constant at $19 million, the plan assets could be invested at a required rate to achieve fully funded status in five years. Thus, the computation to achieve the rate of return is: (Future Value Present Value) (1/term) or using a financial calculator =4.84%. The result of this calculation is 4.84 percent. Additionally, we must also include the benefits currently paid out to retirees of 1 percent plus the expected inflation rate of 1 percent to arrive at the return requirement of 6.84 percent.

This return requirement allows the plan to close the plan deficit while also providing retirement benefits to its retirees and preserving the capital from the effects of inflation.

Risk Tolerance The risk tolerance for the pension plan is low or below average. The primary objective of the plan is to preserve the plan assets and protect it from the effects of inflation with the ultimate goal of achieving a fully funded status in five years. Given the short time horizon of five years and its current underfunded status and the inability of its plan sponsor to commit any fund to the plan (due to bankruptcy), the plan cannot be subjected to any unexpected levels of market risk. Furthermore, it is currently paying out benefits to retirees, so it must have the liquidity to provide such benefits.

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Based on the information provided above, which policy statement has the appropriate language for the endowments investment policy statement with respect to time horizon?

A) Plan B.

B) Plan A.

C) Plan C.

D) Plan D.

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Answer and Explanation

It is assumed, since it was not stated, that the fund will be a permanent source of scholarship funds.

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Based on the information provided above, which policy statement has the appropriate language for the endowments investment policy statement with respect to unique circumstances?

A) Plan A.

B) Plan B.

C) Plan C.

D) Plan D.

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Answer and Explanation

Since Turner is a trustee as well as the donor, this places a unique twist to the governance of the endowment. Asset/Liability matching relates to insurance companies. The financial status of the college has no impact on this independent scholarship endowment (unless, of course, it completely goes under).

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Which of the following choices with respect to tax limitations for endowments is least appropriate?

A) Plan B.

B) Plan A.

C) Plan C.

D) Plan D.

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Answer and Explanation

Endowments are tax-exempt. As such, municipal bonds are not appropriate investment vehicles. Also, the endowment may be subject to the Unrelated Business Income Tax (UBIT).

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Based on the information provided above, which policy statement has the appropriate language for the endowments investment policy statement with respect to regulatory and legal issues?

A) Plan B.

B) Plan A.

C) Plan C.

D) Plan D.

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Answer and Explanation

Except for issues related to 501(c)(3) tax regulations, there are very few federal regulations governing the administration of endowments.

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Based on the information provided above, which policy statement has the appropriate language for the endowments investment policy statement with respect to return requirements?

A) Plan B.

B) Plan D.

C) Plan C.

D) Plan A.

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Answer and Explanation

Assuming the college uses a 5 percent spending rate, 9 percent is the minimum required return annually based off of a 4 percent annual rise in tuition. 11 percent assumes you are double compensating for inflation (4 percent tuition plus 2 percent inflation rate). Matching/relating returns to a benchmark will not insure that scholarships will be given (a request of Turners).

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Based on the information provided above, which policy statement has the appropriate language for the endowments investment policy statement with respect to risk tolerance?

A) Plan A.

B) Plan C.

C) Plan D.

D) Plan B.

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Answer and Explanation

Typically, the risk tolerance of endowment funds is linked to the relative importance of the fund in the sponsors overall budget picture. Since this endowment is a scholarship endowment, there are no operations at risk of shutting down if the fund does not meet its return objective. On the other hand, Turner has expressed that she wants 10 scholarships awarded annually. This requirement reduces the overall risk profile. Also, a 9 percent return requirement will necessitate higher risks.

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Of the items shown in Figure One of Clarksons notebook which is the most important objective for a bank?

A) Item 2.

B) Item 5.

C) Item 1.

D) Item 3.

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Answer and Explanation

The primary objective is to earn a positive interest rate spread which is the difference between the bank's cost of funds and the interest earned on loans and other investments.

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With respect to the descriptions of the three portfolio management approaches detailed in Figure Two of Clarksons notebook:

A) ladder is incorrect; barbell is incorrect; bullet is incorrect.

B) ladder is incorrect; barbell is incorrect; bullet is correct.

C) ladder is correct; barbell is incorrect; bullet is correct.

D) ladder is incorrect; barbell is correct; bullet is correct.

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Answer and Explanation

The ladder strategy approach staggers investments with equal amounts invested throughout the maturity spectrum. Over time, periodic reinvestment of maturing securities is required. With a barbell approach, investments are made both on the short and long ends of the maturity spectrum; weighted more heavily on one end or the other depending upon the managers interest rate outlook. A bullet strategy concentrates the maturities of the bonds in the portfolio around a single point on the yield curve.

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To make an aggressive bet on the interest rate environment that Clarkson anticipates, she should use a:

A) ladder approach and over-weight investments in short-term securities.

B) barbell approach and under-weight investments in short-term securities.

C) barbell approach after interest rates have risen.

D) bullet strategy and over-weight investments in short-term securities.

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Answer and Explanation

The ladder strategy approach staggers investments with equal amounts invested throughout the maturity spectrum. This approach averages exposure to interest rates and does not necessarily require an aggressive bet on interest rate direction. Over time, periodic reinvestment of maturing securities is required. With a barbell approach, investments are made both on the short and long ends of the maturity spectrum; weighted more heavily on one end or the other depending upon the managers interest rate outlook. When rates are expected to rise (as Clarkson anticipates), short-term securities can be over-weighted using a bullet strategy which concentrates securities in one area on the yield curve.

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Regarding their statements about a banks securities that have been classified as available-for-sale:

A) Clarkson is correct; Anderman is incorrect.

B) Clarkson is incorrect; Anderman is correct.

C) Clarkson is correct; Anderman is correct.

D) Clarkson is incorrect; Anderman is incorrect.

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Answer and Explanation

AFS securities are not intended to be held to maturity. Unrealized gains or losses are reported in the banks equity account but are not reported on the income statement. Realized gains and losses and interest dividend income are reported in income. Because bank capital is affected by changes in their market value, highly liquid, and shorter-duration securities are often selected for this category of assets.

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Which of the following statements about hold-to-maturity (HTM) securities held in a banks portfolio is FALSE? HTM securities:

A) can become available for sale if substantial credit deterioration occurs.

B) can become available for sale to meet unforeseen liquidity needs.

C) are valued on the balance sheet at amortized cost.

D) do not report unrealized gains or losses on either the balance sheet or the income statement.

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Answer and Explanation

HTM securities are intended to be held until maturity. In certain circumstances, however, they can become available for sale (e.g. substantial credit deterioration, changes in tax treatments, shifts in risk weightings) but not in response to shifts in interest rates or to meet unforeseen liquidity needs.