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LM5 Case Study in Portfolio Management: Institutional 2024 Level III Notes © IFT. All rights reserved 1 LM5 Case Study in Portfolio Management Institutional 1. Introduction............................................................................................................................... 2 2. Background: Liquidity Management ....................................................................................... 2 Liquidity Profiling and Time-to-Cash Tables ......................................................................... 2 Rebalancing, Commitments ..................................................................................................... 4 Stress Testing............................................................................................................................ 4 Derivatives ................................................................................................................................ 5 Earning an Illiquidity Premium............................................................................................... 5 3. Quadrivium University Investment Company Case: Background......................................... 6 Quadrivium University Investment Company ............................................................................ 6 Investment Strategy: Background and Evolution.................................................................. 7 4. QUINCO Case: Strategic Asset Allocation ................................................................................ 8 5. QUINCO Case: Liquidity Management ................................................................................... 11 6. QUINCO Case: Asset Manager Selection ................................................................................ 14 7. QUINCO Case: Tactical Asset Allocation ................................................................................ 16 8. QUINCO Case: Asset Allocation Rebalancing......................................................................... 18 9. QUINCO Case: ESG Integration............................................................................................... 21 Summary ...................................................................................................................................... 25 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM5 Case Study in Portfolio Management: Institutional 2024 Level III Notes © IFT. All rights reserved 2 1. Introduction Strategic asset allocation (SAA) decisions pose various challenges for institutional investors. This reading explores these issues through a case study of a large university endowment. The case is divided into two major sections. • The first section covers issues related to asset allocation and liquidity management. • The second section explores the use of derivatives for tactical asset allocation and portfolio rebalancing. ESG considerations that arise in the normal course of investing are also explored. 2. Background: Liquidity Management Institutional investors use several tools to manage a portfolio’s liquidity risk, such as: • liquidity profiling and time-to-cash tables, • rebalancing and commitment strategies, • stress testing analyses, and • derivatives. Liquidity Profiling and Time-to-Cash Tables To assess liquidity needs, institutional investors should identify potential cash inflows and cash outflows for a defined investment horizon. This information can be used to create a liquidity classification schedule (time-to-cash table) and an overall liquidity budget. Exhibit 1 from the curriculum presents an example of a time-to-cash table. The liquidity classification is based on the time expected to liquidate an investment at or near market value. The liquidity budget defines what percentage of the portfolio should fall into each time-to-cash bucket (as shown in the last column of Exhibit 1). It specifies weights that are acceptable for each liquidity classification. The liquidity budget reflects the acceptable liquidity requirements of a portfolio in a liquidity stress scenario. The next step is to create a liquidity profile for the portfolio by analyzing the underlying liquidity characteristics of the portfolio investments. Exhibit 2 from the curriculum provides an example of liquidity profiling for a portfolio’s underlying investments.
LM5 Case Study in Portfolio Management: Institutional 2024 Level III Notes © IFT. All rights reserved 3 The table can be read as follows: • Cash represents 1% of the overall portfolio. It is kept in a separate account and is 100% liquid. • Emerging Market Equity represents 12% of the overall portfolio. Of the 12%, 9% is kept in a commingled fund, and 3% is invested in an ETF. Emerging market equity in a commingled fund is 75% moderately liquid and 25% semi-liquid. Whereas, emerging market equity in an ETF is 100% liquid. • Private equity represents 18% of the overall portfolio. It is kept in a single investment vehicle ‘Funds 1-85’. 100% of private equity falls in the illiquid category. • The remaining asset classes’ allocations can be interpreted similarly. • According to the liquidity classifications of the total portfolio, 19% falls in the highly liquid category, 26% in the moderately liquid category, 22% in the semi-liquid
LM5 Case Study in Portfolio Management: Institutional 2024 Level III Notes © IFT. All rights reserved 4 category, and 33% in the illiquid category. These numbers should be compared to the liquidity budget to keep the portfolio within the budget parameters. Rebalancing, Commitments A portfolio is initially constructed as per the desired strategic asset allocation and liquidity profile. But over time, the asset allocation and the liquidity profile can change. Through rebalancing, the portfolio remains close to the original SAA targets and maintains the requisite liquidity profile. The objective of rebalancing is to keep portfolios close to the desired risk levels. Rebalancing of illiquid assets is costly. Asset liquidity decreases when markets are under stress. Hence, sufficient liquid assets should be maintained to facilitate rebalancing. Rebalancing mechanisms include: • Systematic rebalancing policies: Tolerance bands are defined for each asset class weight relative to its SAA. For example, consider a portfolio with an SAA of 50% to equity, 30% to private equity, and 20% to fixed income. Tolerance bands for the three asset classes can be ±5%, ±7%, and ±3%, respectively. Transaction costs, price volatility, and the correlation between asset classes are other variables that are considered in determining band sizes. o Calendar rebalancing: This strategy involves rebalancing the portfolio’s asset allocations to target weights periodically (e.g., quarterly). o Percent-range rebalancing: This strategy involves continuous monitoring of the portfolio’s asset allocation. The percent-range approach requires setting rebalancing trigger points around the asset class’s target weights. When the asset class weight first passes through one of its trigger points, the entire portfolio is rebalanced. • Automatic adjustment mechanisms: These mechanisms are designed to maintain a stable risk profile when exposure drifts from the targeted exposure. Consider a portfolio with two asset classes: equity and private equity. Assume both asset classes have the same beta. If the allocation to private equity increases by 1% versus the target, the allocation to public equities would automatically be adjusted down by 1% to maintain the overall beta. While rebalancing, commitments to illiquid asset classes such as private equity should be considered. Commitment-pacing strategies/ Cash flow models enable investors to: • Manage portfolio liquidity. • Manage desired asset class risk exposures. Stress Testing When the economy is strong and financial markets are performing well, liquidity needs can be met on time. However, during times of market stress, liquidity tends to deteriorate.