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LM1 Portfolio Management for Institutional Investors 2024 Level III Notes © IFT. All rights reserved 1 LM1 Portfolio Management for Institutional Investors 1. Institutional Investors: Types and Common Characteristics.......................................................... 3 Institutional Investors: Common Characteristics............................................................................... 3 2. Overview of Investment Policy ................................................................................................................... 5 3. Pension Funds: Types and Stakeholders................................................................................................. 7 Stakeholders...................................................................................................................................................... 7 4. Pension Funds: Liabilities, Investment Horizon, and Liquidity Needs........................................ 8 Liquidity Needs ..............................................................................................................................................10 5. Pension Funds: External Constraints .....................................................................................................11 6. Pension Funds: Risk Considerations.......................................................................................................12 7. Pension Funds: Investment Objectives and Asset Allocation .......................................................14 Investment Objectives.................................................................................................................................14 Asset Allocation by Pension Plans ..........................................................................................................14 8. Sovereign Wealth Funds: Types and Stakeholders ...........................................................................17 Stakeholders....................................................................................................................................................17 9. Sovereign Wealth Funds: Other Considerations ................................................................................18 Liquidity Needs ..............................................................................................................................................19 External Constraints Affecting Investment.........................................................................................19 10. Sovereign Wealth Funds: Investment Objectives and Asset Allocation .................................20 Asset Allocation by Sovereign Wealth Funds .....................................................................................22 11. University Endowments and Private Foundations.........................................................................22 External Constraints Affecting Investment.........................................................................................23 12. University Endowments: Other Considerations..............................................................................23 University Endowments—Liabilities and Investment Horizon..................................................24 University Endowments—Liquidity Needs ........................................................................................25 13. Private Foundations ...................................................................................................................................25 Private Foundations—Liabilities and Investment Horizon..........................................................26 Private Foundations—Liquidity Needs ................................................................................................26 14. University Endowments: Investment Objectives and Asset Allocation..................................27 14.1 University Endowments.........................................................................................................................27
LM1 Portfolio Management for Institutional Investors 2024 Level III Notes © IFT. All rights reserved 2 Asset Allocation..............................................................................................................................................28 15. Private Foundations: Investment Objectives and Asset Allocation .........................................30 Private Foundations .....................................................................................................................................30 16. Banks and Insurers .....................................................................................................................................31 External Constraints Affecting Investment.........................................................................................32 17. Banks: Other Considerations...................................................................................................................33 Banks—Liabilities and Investment Horizon.......................................................................................33 Banks—Liquidity Needs .............................................................................................................................35 18. Insurers ...........................................................................................................................................................35 Insurers—Liabilities and Investment Horizon..................................................................................36 Insurers—Liquidity Needs ........................................................................................................................36 19. Banks and Insurers: Investment Objectives......................................................................................37 20. Banks and Insurers: Balance Sheet Management and Investment Considerations...........38 21. Banks and Insurers: Investment Strategies and Asset and Liability Volatility....................40 22. Banks and Insurers: Implementation of Portfolio Decisions......................................................44 Summary ................................................................................................................................................................51 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
LM1 Portfolio Management for Institutional Investors 2024 Level III Notes © IFT. All rights reserved 3 1. Institutional Investors: Types and Common Characteristics Institutional investors are corporations, trusts, or other legal entities that invest on behalf of groups or individuals. The main types of institutional investors are: • Pension plans • Sovereign wealth funds • Endowments • Foundations • Banks • Insurance companies Section 1 discusses the common characteristics of institutional investors. Section 2 covers investment policies for institutional investors. Sections 3 to 19 focus on the different types of institutional investors. Institutional Investors: Common Characteristics The common characteristics of institutional investors include: • Scale: They generally have a large scale, i.e., asset size. • Long-term investment horizon: Most institutional investors have a long-term investment horizon. • Regulatory framework: Institutional investors are subject to regulatory frameworks that vary by country and jurisdiction. • Governance framework: They typically have a clearly defined governance model. • Principal-agent issues: Since institutional investors invest on behalf of others, they need to manage principal-agent issues properly. Scale The scale of institutional investors can range from relatively small (less than USD 25 million) to relatively large (more than USD 10 billion). Challenges faced by small institutions may include: • Inability to access certain investments such as private equity and hedge funds because these may have a high minimum investment size requirement. • Difficulty in hiring skilled investment professionals. They are more likely to outsource investments to external asset managers or investment consultants. As the scale becomes larger, it becomes easier to access a wider investment universe and hire talented investment professionals. However, some of the challenges faced by very large institutions may include: • Inability to invest in certain capacity constrained asset classes such as venture capital funds and small-cap stocks. • Higher trading costs due to the market impact of their large orders.
LM1 Portfolio Management for Institutional Investors 2024 Level III Notes © IFT. All rights reserved 4 Long-Term Investment Horizon Pension funds, sovereign wealth funds, endowments, and foundations all typically have: • long investment horizons • low liquidity needs • modest cash requirements as a percentage of AUM This allows them to invest in a wide range of alternative asset classes such as private equity, real estate, hedge funds, etc. On the other hand, banks and insurance companies are often forced to invest in more liquid instruments because of: • More asset/liability focus. • Operating within a tight regulatory framework designed to ensure capital adequacy. Regulatory Frameworks Institutional investors are subject to legal, regulatory, tax, and accounting frameworks. These frameworks define a set of rules that must be followed. The frameworks vary by the national jurisdiction in which the company operates. Some examples of the framework include: United States: • Employee Retirement Income Security Act (ERISA) • Pension Protection Act (PPA) • Uniform Prudent Management of Institutional Funds Act (UPMIFA) European Union: • Institutions for Occupational Retirement Provision (IORP) II South Korea: • Employee Retirement Benefit Security Act Australia: • Superannuation Industry (Supervision) Act (SIS Act) International: • International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB) • International Organization of Securities Commissions (IOSCO) Regulatory frameworks differ in complexity and are often evolving. Regulatory bodies, such as IASB and IOSCO, supervise institutional investors globally. The key drivers of the legal and regulatory frameworks are investor protection, safety, and soundness of financial institutions, and the integrity of financial markets.