0
Q
Endowment
A
- Donated pool of capital
- intended to maintain the real value of its assets in perpetuity + provide an annual income to support a purpose specified by the donor (like an operating budget)
- can be set up by a school, hospital, museum or religious institutions etc
1
Q
Factors that have contributed to less use of defined benefit plans
A
- Lack of affordability
- Regulatory changes (must disclose funded status)
- Equity risk (low multiples for underfunded pensions)
- Lack of portability
2
Q
Operating foundations
A
- most like endowments
- income generated used to fund operations
3
Q
Community foundations
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- located in a specific geographic region
- distribute gifts and investment returns received as grants to other charities in local community
4
Q
Corporate foundations
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- sponsored by corporations
- tend to donate to local charities in regions in which the company has the most employees / customers
5
Q
Independent foundations
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- funded by an individual or a family
- often with a single gift in the form of stock
6
Q
Tail risk
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Risk of catastrophic loss to a portfolio value
7
Q
2 challenges to PMs of independent foundations
A
- Undiversified portfolio
- No additional donations after the first
9
Q
Ways to reduce tail risk (4)
A
- Increase allocations to cash and risk free debt (lowers return so not used by most endowments)
- Option hedges in equity linked portion of portfolio
- Basket hedging approach
- Structure allocations within each asset class to reduce exposure to extreme events (i.e. reduce arb-strategies; increase macro/managed futures)
9
Q
Basket hedging approach
A
- more opportunistic
- buys option hedges when they are cheap and sells the hedges when they are expensive
10
Q
Equity option hedges
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- long equity put options
- most pure hedges against tail risk
- can be expensive
11
Q
3 types of pension funds
A
- Defined benefit
- Social security (government plans)
- Defined contribution
12
Q
Advantages of pension funds (vs individual investor retirement savings)
A
- Highly trained staff/external managers to monitor investments
- Economies of scale (larger staff –> lower fees)
- Can make long term investments
14
Q
Defined Benefit (DB) plan
A
- Employer sponsored
- formula based on salary and years of employment
- asset allocation decisions made by employer
- provides guaranteed income
- employer bears investment risk
- not portable
- long vesting periods
15
Q
Accumulated benefit obligation(ABO)
A
PV of accumulated benefits
16
Q
Projected benefit obligation (PBO)
A
- PV of benefits for future retirees.
- More challenging to calculate.
- As yields increase, PBO declines (duration risk/bond like)
16
Q
Surplus risk
A
The pension assets’ tracking error relative to the present value of the liabilities. If assets and liabilities have a negative correlation over time, surplus risk is high
17
Q
Frozen pension plans
A
Employees scheduled to receive DB plans do not accrue additional years of service in the plan
18
Q
Surplus risk
A
The pension assets’ tracking error relative to PV of liabilities. If assets and liabilities have a negative correlation over time, surplus risk is high
20
Q
Goals of Pension Plans asset allocation (2)
A
- Earn high return (used to reduced future contributions)
2. Minimize underfunding or surplus risk
20
Q
Defined Contribution (DC) plan
A
- Employee and employer contribute
- employer does not have surplus risk since A=L
- portable
- asset allocation made by employee
- longevity risk borne by employee
- not permitted to invest directly in alternative investments
21
Q
4 key dynamic strategies for asset allocation
A
- Buy and hold (linear/convex payoff)
- Constant mix (concave)
- Constant proportion portfolio insurance (convex)
- Option based portfolio insurance (convex)
23
Q
Payoff diagram
A
- portfolio value (Y) relative to market value (X)
24
Q
Exposure diagram
A
- stock investment (Y) relative to portfolio value (X)
- represents investor’s risk tolerance
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Buy and hold strategy
- buy initial asset mix
- no rebalancing
- linear relationship
- Payoff diagram: m=initial % in stock, crosses y-axis at T-bill investment
- Exposure diagram: m=1, crosses x-axis at T-bill investment
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Constant mix strategy
- maintains an exposure to stocks that is a constant proportion of wealth
- investors hold stocks at all wealth levels
- risk tolerance levels vary based on levels or wealth
- concave payoff
- 0 angle allows it to always dominate the buy and hold strategy
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Constant proportion portfolio insurance (CPPI)
- involves the investor selecting a floor and then calculating a cushion that represents the excess of the portfolio value
- amount allocated to risky asset is based on cushion and based on a pre determined multiplier
- Allocation to stock = m (A-F) where A - F is the cushion
- buy stocks if prices increase
- sell stocks if prices decrease
- its basically a momentum strategy that does well in bull markets. In a bear market, the strategy will perform at least as well as its floor
- m > 1
- convex payoff
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Carry investing
Involves selling low-yielding assets and using the proceeds to purchase high yielding assets. Commonly applied in currency markets
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Option based portfolio insurance (OBPI)
- specifies an investment horizon and a desired floor at the horizon
- its a version of the CPPI strategy where the multiplier changes as the cushion changes
- convex payoff
- m> 1
- variation of CPPI
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Option based portfolio insurance (OBPI)
- specifies an investment horizon and a desired floor at the horizon
- its a version of the CPPI strategy where the multiplier changes as the cushion changes
- convex payoff
- m> 1
- variation of CPPI
- has a portfolio insurance nature and is appealing to investors with long horizons
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Corpus
nominal value of initial donation that needs to be maintained
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Liquidity Driven Investing
Match liquidity to investment horizon using 3 tiers (not risky & liquid, risky & liquid, risky & illiquid)
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Buy and Hold diagrams
- linear/convex
- Payoff: m=initial % in stock, y-intercept: T-bill investment
- Exposure: m=1, x-intercept: T-bill investment, Risk tolerance: + when value > T-bill investment
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Ways to improve liquidity for endowments
1. Stagger allocations to PE funds
2. Spread new capital commitments over several years
3. Grow gift income, borrow, or reduce allocation to alternatives
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CPPI diagrams
- Payoff: convex
| - Exposure: m>1, x-intercept=F, + risk tolerance when value > F
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Constant Mix diagrams
- Payoff: concave, this is the only one with concave payoff
- Exposure: m=% invested in stock (<1), + risk tolerance, little downside protection
- vertical intercept; T-bill
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Ways to Reduce Risk
1. Increase investments in riskless assets
2. Use insurance products (eg. options)
3. Use diversification (best approach)
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5 Style strategies as sources of expected return
1. Value
2. Carry (sell low-yielding/buy high-yielding)
3. Trend and momentum
4. Volatility
5. Liquidity
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3 components of investment returns for endowments and foundations
1. Strategic asset allocation: ~93% of pension returns and 74% of endowment returns
2. Security Selection
3. Market timing/ tactical asset allocation: this was key for the Yale endowment
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Change in endowment value
= Income from gifts - spending + net investment returns
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Ways to reduce tail risk in endowment funds
1. implement an equity option hedge (ex: buy equity put option)
2. Implement an opportunistic hedging approach that busy options when they are cheap and sells them when they are expensive
3. Adjust structural allocation within each asset class to reduce exposure to extreme events (ex: invest in high quality bonds or in hedge strategies that perform well in crises, such as macro funds or managed futures)
4. Increase allocation to cash and/or risk-free debt but this reduces expected returns so is not a smart play
41
3 tiers of liquidity driven investing for endowments and foundations
Tier 1: not risky and liquid (ex: ST FI instruments)
Tier 2: risky and liquid (ex: stocks)
Tier 3: risky and illiquid (ex: PE and hedgies)
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Ways to improve liquidity or avoid liquidity crises for endowments/foundations
1. Stagger allocations to PE and RE funds over several years where distributions from maturing funds are used to fund capital calls of more recent vintages
2. Grow the endowment's gift income
3. Borrow funds
4. Reduce exposure to less liquid alternative assets (ex: PE and hedgies with long lock ups)
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Endowment return target (ERT)
ERT = rate of inflation + payout ratio
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Inflation Beta efficacy (highest to lowest)
```
Commodity futures(+6.5)
Farmland(+1.7)
TIPS
Treasury Bills
US Equities(-)
Treasure bonds (-)
```
45
Tactical Asset Allocation (TAA) models of endowment funds
Usually long only and do not employ leverage
| Constrain investments to a small number of macroeconomic markets
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Dynamic strategies' rate of increase in risk tolerance
Fastest for CPPI (and OBPI) given that m > 1
Next faster for buy and hold with m = 1
Slowest for constant mix with m < 1
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Trending vs Flat Markets (for dynamic asset allocation)`
In trending markets, i.e when markets move in one direction the expected performance of convex payoff curves (buy/hold, CPPI and OBPI) dominate. The CPPI will do very well in an up market and will perform no worse than the floor in a down market. The OBPI will have a similar payoff to that of the CPPI.
In flat but oscillating markets, concave payoff curves (the only one here is the constant mix strategy) dominates b/c it exploits price reversals by buying when prices fall and selling when prices increase. This superior performance is amplified in more volatile markets. The CPPI and OBPI perform poorly due to rebalancing.
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US Pension Protection Act of 2006
Requires that corporate employers disclose the plan's funded status to plan participants and require employer contributions to match the funding status.
Underfunded plans must increase contributions such that the plan is fully funded within 7 years
Merton ('06): companies with large pension deficits may have lower earnings and book value multiples, exhibit higher stock volatility and have higher betas which can increase the firm's WACC
