Managing Institutional Investor Portfolios －LO companies, contrast, insurance, investment

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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 i: Compare and contrast the investment objectives and constraints of foundations, endowments, insurance companies, and banks.

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Following completion of the return objectives, Simon proofs the remaining sections of Exhibit A. For foundations, which of the remaining sections are NOT correct?

A) Time horizon, tax, liquidity & income.

B) Risk tolerance, time horizon, legal & regulatory.

C) Risk tolerance, liquidity & income, legal & regulatory.

D) Tax, liquidity & income, unique constraints.

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Answer and Explanation

Foundations often have finite lives whereas endowments typically have infinite horizons. Private foundation investment income is taxable, whereas community foundations and endowments are not. Private foundations are required to pay out at least 5 percent of assets on an annual basis. Endowments do not have minimum spending requirements. Foundations may also be able to decrease grant-making activity if investment returns have declined, in contrast to most endowments that need stable, inflation-protected income, and sufficient liquidity to fund the ongoing operations of a specific entity.

The risk tolerance of endowments is generally lower than foundations due to short-term budgetary needs (income and liquidity) of the sponsored organization, but can vary due to other factors such as the risk tolerance of the trustees/investment committee, the size of the principal, long-term return goals, etc. Foundation risk tolerance is critically linked to time horizon, but is also influenced by the risk tolerance of the board, principal size, etc. However, foundations are often more aggressive than endowments. Unique constraints may vary widely, but social investing is a typical concern of foundations and endowments.

The risk tolerance of endowments is generally lower than foundations due to short-term budgetary needs (income and liquidity) of the sponsored organization, but can vary due to other factors such as the risk tolerance of the trustees/investment committee, the size of the principal, long-term return goals, etc. Foundation risk tolerance is critically linked to time horizon, but is also influenced by the risk tolerance of the board, principal size, etc. However, foundations are often more aggressive than endowments. Unique constraints may vary widely, but social investing is a typical concern of foundations and endowments.

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Which of the following best describes the major difference between the time horizon constraint of a foundation and of an endowment?

A) Foundations may have an infinite life, whereas endowments always have finite lives.

B) Endowments and foundations both have infinite lives.

C) Endowments and foundations both have finite lives.

D) Foundations may have a finite life, whereas endowments typically have infinite lives.

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Answer and Explanation

Foundations often have finite lives whereas endowments are generally established for infinite time horizons.

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A publicly-sponsored organization that makes grants for charitable, religious, social or educational purposes is a (an):

A) community foundation.

B) private or family foundation.

C) company-sponsored foundation.

D) endowment.

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Answer and Explanation

Community foundations are publicly-sponsored entities with boards consisting of community representatives. Community foundations have no annual spending requirements. Other types of foundations may also be organized to fund charitable, social educational or religious purposes, but are not public-sponsored or operated. Endowments are not generally grant-making entities.

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Which of the following most accurately depicts the tax treatment of a private foundation and an endowment?

A) Endowment investment income is taxable, whereas private foundation investment income is not.

B) Community foundation investment income is taxable, whereas endowment investment income is not.

C) Operating foundation investment income is taxable, whereas endowment investment income is not.

D) Private foundation investment income is taxable, whereas endowment investment income is not.

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Answer and Explanation

Private foundation investment income is taxable, whereas the income of other foundations and endowments is generally not taxable.

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With respect to Graingers and Simons statements concerning the spending policies of the different types of foundations:

A) Grainger is incorrect; Simon is incorrect.

B) Grainger is correct; Simon is incorrect.

C) Grainger is incorrect; Simon is correct.

D) Grainger is correct; Simon is correct.

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Answer and Explanation

Both Grainger and Simon are correct. Independent (private and family foundations are independent foundations), operating, and company-sponsored foundations are subject to minimum spending requirements of some kind. Community foundations are not. Although Simon did not mention operating and company-sponsored foundations, his statement is still correct.

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Distinguishing characteristics between regular foundations, private foundations, and endowments are:

A) endowments must generate their entire operating budget from portfolio assets, and private foundations are required to pay out a minimum of 5 percent of assets annually.

B) foundations must generate their entire operating budget from portfolio assets, and endowments are required to pay out a minimum of 5 percent of assets annually.

C) foundations usually generate their entire operating budget from portfolio assets, and private foundations are required to pay out a minimum of 5 percent of assets annually.

D) endowments must generate their entire operating budget from portfolio assets, and endowments are required to pay out a minimum of 5 percent of assets annually.

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Answer and Explanation

Foundations usually generate their entire operating budget from portfolio assets, and private foundations are required to pay out 5 percent of assets annually.

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Endowment investment policy statements usually pay attention to the liquidity constraint determined by spending requirements. Which of the following statements most accurately represents an endowments relationship to spending? Endowments:

A) use spending rules to minimize spending volatility.

B) use spending rules to maximize spending.

C) use spending rules to maximize asset consumption.

D) no longer use spending rules to estimate spending levels.

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Answer and Explanation

To minimize adverse impacts of spending volatility, endowments often employ spending rules that tend to minimize spending level volatility.

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A life insurance companys liquidity requirement differs from a non-life insurance companys requirement in that a life insurance companys liability structure is uncertain in its:

A) amount, while a non-life insurance company's liability structure is uncertain in both its amount and timing.

B) timing and amount, while a non-life insurance company's liability structure is also uncertain in its amount and timing.

C) amount, while a non-life insurance company's liability structure is uncertain in its amount.

D) timing, while a non-life insurance company's liability structure is uncertain in both its amount and timing.

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Answer and Explanation

Life insurance companies have liability structures that are uncertain in timing but not amount. Non-life insurance companies have liability structures that are uncertain in both amount and timing.

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Which of the following statements concerning foundations and endowments is TRUE?

A) Foundations are grant-making institutions and may have variable time horizons; endowments are established to permanently fund some activity, and typically have minimum payout requirements.

B) Foundations are established to permanently fund some activity and have high degrees of risk tolerance.

C) Foundations are grant-making institutions and may have variable time horizons; endowments are established to permanently fund some activity, and typically have infinite lives.

D) Endowments are grant-making institutions and typically have low degrees of risk tolerance.

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Answer and Explanation

Foundations are grant-making institutions and may have short or long (infinite) lives. Endowments are established to permanently fund some activity (e.g., provide scholarships) and typically have infinite lives. Endowments typically do not have minimum payout requirements. Both types of institutions typically have fairly high degrees of risk tolerance if they are long-lived.

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The primary reason for an endowment to establish a spending rule is to:

A) minimize variance in portfolio value.

B) enhance long-term protection of principal.

C) minimize spending fluctuations.

D) ensure the cash flows of the endowment maintain their purchasing power.

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Answer and Explanation

The primary reason for the establishment of a spending rule is to minimize spending fluctuations, since large fluctuations will undermine the objective of the endowment. The spending rule is typically based on portfolio value, but does not minimize variance in the value. Spending rules can affect the long-term value of the principal and the purchasing power, but these are secondary objectives in the establishment of a spending rule.

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Compared to the average time horizon of his current clients, the time horizon of the investment company and endowment fund will be:

Investment Co.

Endowment Fund

A) shorter longer

B) longer shorter

C) longer longer

D) shorter shorter

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Answer and Explanation

Both the endowment and investment company would have longer horizons than Monarchs current clients. Institutions generally have longer horizons than individuals, and this is especially true given that Monarchs clients are retired or near retirement.

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Which of the three situations (his current clientele, the investment company, or the endowment fund), would have the fewest tax considerations?

A) The endowment fund.

B) The investment company.

C) His current clientele.

D) There is no clear answer.

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Answer and Explanation

An endowment fund does not have to consider taxes. Although, an investment company manager is judged primarily on the total pretax return, the public is paying increasing attention to the tax implications of funds with high turnover rates.

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Which of the three situations (his current clientele, the investment company, or the endowment), would require the most attention to generating a positive alpha?

A) The endowment.

B) The investment company.

C) His current clientele.

D) There is no clear answer.

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Answer and Explanation

Alpha is a standard criterion for measuring the success of an investment company. Although alpha could be used to measure Monarchs success as the endowment manager, the endowment has other criteria such as loss aversion and social consciousness. Thus, alpha would not be the primary focus. Persons that are retired or near retirement have many priorities that exceed alpha in importance.

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With respect to the statements made by Monarch and Linn comparing foundations and endowments:

A) Monarch is incorrect about taxes and incorrect about functions; Linn is correct about taxes and correct about functions.

B) Monarch is incorrect about taxes and correct about functions; Linn is correct about taxes and incorrect about functions.

C) Monarch is correct about taxes and correct about functions; Linn is incorrect about taxes and incorrect about functions.

D) Monarch is correct about taxes and incorrect about functions; Linn is incorrect about taxes and correct about functions.

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Answer and Explanation

Foundations are subject to excise taxes between1-2% on net investment income. Any unrelated business income is exposed to regular corporate tax rates. In addition to grant-making, foundations can be primary sources of ongoing funding for charitable programs.

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Monarch thinks he might be questioned about the predictive power of an investment managers past performance. Which of the following factors is least likely to help when projecting how well a manager will do in the future is:

A) whether the performance was evaluated relative to a style benchmark.

B) what time frame was used to measure performance.

C) the managers nominal return.

D) the consistency of the managers performance.

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Answer and Explanation

The nominal return itself provides limited information for gauging a managers future success. Risk-adjusted returns and returns relative to a style or index benchmark are more useful. Other important factors to consider are the investment process, who the investment decision-makers are, the time frame, the presence of dependable staff, the size of the portfolio, and the consistency of the performance.

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The return objectives for a life insurance company can be broken into two segments, the fixed-income and the surplus segments. Which return objectives are mostly associated with each segment, respectively?

A) Spread management and maximizing yield.

B) Spread management and capital gains.

C) Yield maximization and spread management.

D) Capital gains and yield maximization.

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Answer and Explanation

The return objectives for a life insurance company have mainly been associated with earning a competitive return that helps increase the spread between assets and liabilities. The surplus portfolio, however, has growth in the surplus as its main return objective, which will happen via capital gains.

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The time horizon of a non-life insurance company differs from that of a pension fund in that a nonlife insurance companys time horizon:

A) is quite long due to the uncertainty of the liability structure associated with policies sold, whereas a pension fund's time horizon will be much shorter due to the finite life of employees.

B) may be quite short and will depend upon the characteristics of policies sold, whereas a pension fund's time horizon may be much longer, depending on workforce characteristics.

C) is dependent on the uncertainties of policies sold, whereas the time horizon of a pension fund is a direct consequence of the business cycle.

D) is not dependent on the business cycle, whereas a pension fund's time horizon is directly related to the business cycle.

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Answer and Explanation

Due to the uncertainty associated with the characteristics of policies sold and when claims will be paid, the time horizon of a nonlife insurance company will necessarily be short. A pension fund, however, will have a time horizon typically longer than that of a nonlife insurance company. The pension funds time horizon will be directly related to the plan sponsors workforce characteristics.