Financial Education

The investment choices of defined benefit plans are often constrained by regulations. In addition, the plan must maintain sufficient liquidity to fund the current benefits.

Plans using asset-only management attempt to minimize standard deviation relative to the required return.

Plans using an asset/liability management approach attempt to control:

• Shortfall risk (the risk of falling below a given level of assets)
• The volatility of the pension surplus
• The volatility of contributions to the plan

Return Objective

• Qualitative objectives describe the investor’s fundamental goals (Pay for retirement)
• Quantitative objectives specify the return needed to achieve the goals (Earn 5% real return per year on average)
• Compounding effects must be considered. This implies the use of geometric average return and multiplicative (1.05 X 1.03) rather than additive (5% real + 3% inflation) formulations

Risk Objective

• Qualitative risk objectives express risk tolerance as above or below average
• Quantitative risk objectives can take several forms, including a risk aversion measured through an interview process; acceptable levels of volatility; the risk of a shortfall; or a safety-first criterion.

Emerging economies can be seen as catching up to developed countries economically. They tend to need higher investment rates in physical and human capital. If domestic savings are insufficient to cover this investment, foreign capital may be needed.

Emerging economies have more volatile political and social environments, and may require structural reform to unlock their potential. They tend to be commodity-driven, or dependent upon a narrow industrial niche.

To assess country risk, investors need to ask:

1. How sound are fiscal and monetary policies?
2. What are the economic growth prospects?
3. Is the currency competitive, and are external accounts under control?
4. Is external debt under control?
5. Is liquidity plentiful?
6. Is the political situation supportive of the required policies?

Most forecasts are prepared based largely on the past performance of the assets in question. However, the present situation may be unlike the past.

Potential differences that could alter the risk/return characteristics of asset classes include technological change, political change, legal and regulatory environments and disruptions such as war or natural disaster.

These so-called regime changes result in non-stationarity, which simply means differing underlying properties during different parts of a time series.

The amount of data required for some statistical analyses may require a long time series, which further increases the risk of non-stationarity in the data. For some time series, information may not even be available for a sufficient historical period.

Banks face a mismatch between assets and liabilities that strongly influences investment policy. Typically, banks receive deposits that are short-term in nature but lend funds on a long-term basis (i.e. mortgages.)

Risk objective

Managing the asset/liability mismatch is a primary concern that results in below average tolerance of risk.

Return objective

Earn a positive spread over the rates paid to depositors.

Constraints

Liquidity needs are significant, both to cover net depositor withdrawals and to facilitate lending. In order to balance the asset/liquidity management, interest rate risk and return requirements the time horizon tends to be intermediate-term in nature. Portfolios are fully taxable, and there are legal and regulatory restrictions on the amounts that can be invested in equities or non-investment grade bonds.

This article was originally written by Richard Wilson in his Hedge Fund Blog.

Prime Broker Definition
A large bank or securities firm that provides various administrative, back-office and financing services to hedge funds and other professional investors. Prime brokers can provide a wide variety of services, including trade reconciliation clearing and settlement, custody services, risk management, margin financing, securities lending for the purpose of carrying out short sales, record keeping, and investor reporting. A prime brokerage relationship doesn’t preclude hedge funds from carrying out trades with other brokers, or even employing others as prime brokers. To compete for business, some prime brokers act as incubators for funds, providing office space and services to help new fund managers get off the ground.

Hybrid retirement plans such as cash balance plans are an attempt to combine the best benefits of traditional defined benefit and defined contribution plans. They combine the portability of assets, ease of administration and understandability for participants of a defined contribution plan with the benefit guarantees, link between benefit and years of service, and ability to link retirement income to a percentage of salary found in a defined benefit plan.

In most hybrid plans, the employer bears investment risk as with a defined benefit plan. The employee receives a statement outlining individual ownership as with a defined contribution plan.

Another common employee benefit is a stock ownership plan (ESOP), which encourages employees to take an ownership stake in their employer. Regulations of such plans vary from country to country, with some requiring employee contributions and others prohibiting them. Shares may or may not be offered to employees at a discount to their market value. In any case, employees participating in an ESOP need to pay special attention to the overall diversification of their investments. This is particularly important in an ESOP because the employee has both human and financial capital at stake in the company.

The compound annual growth rate is a number that represents a steady level of growth from a beginning value to an ending value. It can be thought of as a way to smooth out uneven returns.

To calculate the CAGR of an investment over a period of n years, you would take the nth root of the total percentage return.

Consider a beginning investment of $100 and an ending investment of $161. 161/100 = 1.61. The fifth root of 1.61 is equivalent to 1.61 to the power of 1/5, or 1.1. Subtracting 1 (100% or the initial investment) gives 0.1, or 10%. The CAGR in this case is 10%.

Since the CAGR smooths out uneven returns, it fails to account for the risks taken to achieve the return.  Any series of returns that starts at 100% and ends at 161% five years later will have a 10% CAGR, such as the investments in column A and Column B below.

Column A actually grew at 10% per year. Column B had large positive gains in some years and large negative gains in others, but ended at the same value. Many investors would prefer the investment in Column A due to its greater predictability and equivalent terminal value.

An investment policy statement (IPS) summarizes a client’s circumstances, objectives, and constraints and outlines policies to accommodate them. It is a document of understanding that can help protect both the client and the adviser.

For clients, developing an IPS can be an educational process that results in greater understanding of the investment process and less reliance on blind faith in an adviser. If a second opinion or change in advisers becomes necessary, the document can help the new adviser appreciate the situation.

For an adviser, having the IPS creates a framework for decisions that can be referred to when particular decisions are questioned.

The earnings yield is a company’s earnings per share divided by its price per share. Earnings yield has frequently been used to predict real return for stocks. Since earnings are not reported on a real basis, Stephen Wilcox presented a technique in the September/October 2007 Financial Analysts Journal to adjust earnings yield to better represent real return. Statistical tests show that this measure better predicts future real returns than other popular valuation measures.

There are two primary adjustments considered:

• An accounting adjustment to convert historical cost measures to current value
• An adjustment to liabilities to reflect the real cost of capital as principal values erode due to inflation