Nw pnsn fd invstmnt
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- Trustees’ program structure re pension fund investment:
- 1] Retain professional expertise – admin staff, attorneys (legal counsel help determine trustees’ fiduciary responsibilities), actuaries, auditors, investment advisers, etc. 2] Develop financial profile – assets; obligations for retirees and beneficiaries, etc., expected future contributions 3]Adopt investment policies – return objectives, risk constraints, diversification requirements 4]Formalize investment program – investment committee, asset allocation plan, portfolio management strategies, monitoring/evaluation/control
- Types of money managers (who buy and sell securities according to investment strategies and market conditions):
- 1] Bank trust dept – offer balanced funds and pooled funds (e.g., fixed income or stock or even mutual funds) 2] Money management firms (SEC registered advisers) – invest directly on clients’ behalf – may also do same as bank trust depts. 3] Specialty managers – real estate, international securities, etc. 4] Index funds managers – portfolio consists entirely of stocks or bonds held in amounts proportionate to the representation in a market index
- Formal investment policies typically involve 3 sections:
- 1] Rate of return target or objective is set forth 2]Risk constraint statement – identify system’s tolerance for risk – can be expressed in relation to overall market or in absolute terms 3]Diversification (cannot eliminate risk) statement – to ensure individual losses don’t undermine the entire portfolio
- Formalized investment program typically involves 7 related activities:
- 1] Big picture portfolio analysis – s/b studied in the context of its objectives and funding requirements; primary components; recent performance compared w/ general market indices 2]Asset allocation 3]Money manager selection 4]Strategic decision making 5]Monitoring and controlling performance 6]Evaluation and adjustments 7]Reporting
- Asset classes include
- cash equivalents (short-term investments usually considered risk free); bonds and other fixed income securities; stocks; real estate, venture capital, etc.
- Cash serves two purposes:
- provides reserve buying power so that bargains can be bought as they are discovered; AND purchase other assets when the time is right – portfolio trustees should have their assets in cash when they believe other vehicles are overpriced.
- Trustees must be familiar w/ the legal restrictions that typically include state statutes or local laws that govern:
- 1] Composition and operations of the board of trustees 2] Fiduciary responsibilities (keep minutes, inappropriate decisions, limitations on behavior) 3]Specific investments of pension plans
- 3 general forms of authorization for legal authority for investments:
- 1] specific legal list – identifies instruments that may be allowed 2] insurance company clause – restricts pension fund’s investments to instruments otherwise allowed by regulated insurance companies w/in the state 3]prudent investment clause
- The long term investment objective of a pension fund is
- to obtain a good return on investment consistent w/ the risk tolerances of the plan sponsors, trustees and the fund itself.
- Diermeier’s 1985 studies of long-term investment returns are attributed to
- 86% asset allocation (by far the most important reason that an investment portfolio will do well or poorly); 7% timing of transaction and 7% securities selection.
- In a market economy, the production of goods and services depends upon two factors of production:
- : labor and capital
- Investment professionals measure risk in a different quantitative way thru measurement of volatility defined as
- statistical measure of the frequency and size of deviation from an average return). Volatility is measured thru use of term called standard of deviation (premised on probability theory) – w/c defines a probable range w/in w/c prices would be likely to fluctuate.
- Unsystematic risk vs systematic risk
- Unsystematic risk – risk attributable to only a specific stock or bond Systematic risk (most impt for portfolios w/c are already diversified)– risk of owning the entire class of securities
- The only way for pension fund trustees to minimize the risk to their portfolio of an entire market sector collapsing is thru
- the allocation of assets into unrelated investments – to do this, investor must fund instruments that have good long term return prospects but are likely to perform differently in the short run. The ideal investments would be those w/c produce good long term returns but move in opposite directions in the short run thereby canceling each other’s short term volatility
- Correlation
- degree to w/c one asset goes up in value when another also goes up in value. Perfectly correlated assets increase in identical proportions and would have correlation coefficients of +1.0 – on the other hand, if an asset goes up in value and another declines in value, they are inversely correlated and would have a negative correlation coefficient. The lower the correlations, the more likely that it is possible to improve returns w/o adding risks or to diminish the risk of a given level of return.
- 2 Ways to approach the process of a normal asset allocation plan:
- Naïve investment approach – attempts to replicate a normal universe – e.g., naïve global approach w/c simply mirrors the world portfolio or naïve public universe investing w/c attempts to duplicate the asset allocation used by other public funds AND Liability sensitive approach – tries to tailor the portfolio to the fund’s liability profiles (the projected future payments to beneficiaries)
- The typical result of a strategic asset allocation policy will be
- a target level for asset percentages.
- If a policy shift is desired in response to changing capital markets, it is most likely to fall into the category of
- (involves opportunities to acquire undervalued assets for potential appreciation or extraordinary income) asset allocation or asset timing.
- Underweight stocks
- means to hold stocks less than their normal or strategic % of the portfolio.
- In asset timing, the most popular techniques involve financial models that examine
- economic fundamentals
- The selection of portfolio managers s/b driven by
- the asset allocation process, and not the reverse. This means the role of a given manager s/b pre-determined by the board of trustees or the investment committee on the basis of a portfolio master plan.
- Portfolio manager selection process includes 8 steps
- 1] Establishing criteria 2]Selecting potential candidates 3]Gathering information 4] Analyzing data 5]Choosing candidates to interview 6]Interviewing finalists 7] Negotiating contract 8]Distributing assets
- The final stage of the pension investment program is
- the reporting (to the constituents) function: aside from accounting reports in the notes to financial statements; should include: asset allocation; comparison between target or asset allocation plan and the current one; narrative description of any special asset allocation studies/major developments in the capital market and changes in financial managers.