Chapter 24 PROFESSIONAL AND INSTITUTIONAL ,MONEY MANAGEMENT Seeking the Help of Experts
Chapter 24
PROFESSIONAL AND INSTITUTIONAL ,MONEY
MANAGEMENT
Seeking the Help of Experts
Outline
• Difference between Individual investors and Institutional
Investors.
• Structures of Professional Money Management
• General Principles of Asset-Liability Management
• Institutional Investors
• Portfolio Management Service
• Hedge Funds
• Three Errors of the Investment Management Industry
Differences Between Individual Investors and Institutional Investors
According to Kaiser, the key differences between individual investors and institutional investors are as follows: 1. Individuals define risk as “losing money,” whereas institutions define risk
in terms of “standard deviation of return.”2. Individuals can be categorised by their personalities (or psychographics)
whereas institutions can be categorised by the investment characteristics of their beneficiaries.
3. Individuals enjoy great freedom to invest the way they want, whereas institutions are subject to various legal con straints.
4. Taxes often matter a great deal for individual investors, whereas many institutions such as mutual funds, pension funds, and insurance
companies are tax-exempt entities. 5. Individuals are generally defined financially by their assets and goals
(particularly in relation to their stage in their life cycle), whereas Institutions are generally defined by packages of assets and liabilities.
Structures of Professional Money Management
Private Management Firms Investment Companies
• Personalised solution
• Separate account
• Fee consists of a fixed
component and a variable
component
• Generic solution
• Commingled account
•Fee is a fixed percentage of
the NAV
Risks Associated with Financial AssetsAn investor is exposed to one or more of the following risks when investing in financial assets.
Risk ExamplePrice risk The market price of the asset falls Default risk The issuer of the asset is unable to meet its
obligations Inflation risk Due to inflation, the real value of the asset is
erodedExchange rate risk Due to a change in exchange rate, the value of a
foreign-denominated asset falls Reinvestment risk The cash flow received from an asset has to be
invested in a similar asset that offers a lower return
Liquidity risk An asset cannot be sold easily at a fair priceCall risk The issuer of an asset exercises its right to
redeem the asset prematurely
Nature of Liabilities
Liability Type
Amount of Cash Outlay
Timing of Cash Outlay
Example
Type A Known Known Fixed rate deposit in a bank
Type B Known Uncertain A whole life assurance policy (non-participating)
Type C Uncertain Known A two-year floating rate certificate of deposit
Type D Uncertain Uncertain An automobile insurance policy
Asset-Liability Management
As Alfred Weinberger put it, “Asset/liability management is the
prudent assessment of trade-offs. The emphasis from the
asset/liability perspective is on risk control, but it is important not to
lose sight of the other axis, that of profit or return enhancement.”
Types of Surpluses
Three types of surpluses may be calculated by institutions:
• Economic surplus
• Accounting surplus
• Regulatory surplus
• Economic surplus = Market value of assets – Market value of
liabilities .
• Accounting surplus is calculated on the basis of periodical financial
statements prepared by a financial institution in conformity with the
generally accepted accounting principles (GAAP)
•Regulatory surplus is the surplus on the basis of financial statements
prepared accounting to Regulatory Accounting Principles (RAP),
prescribed by the regulator governing a given institution. RAP may not
be fully congruous with GAAP
•
Accounting Treatment of Financial Securities
• As far as financial securities are concerned, the accounting treatment depends on how the security is classified.
• There are three classifications for securities:• Held-to-maturity• Available for sale• Held for trading.
The held-to-maturity account includes assets that the institution plans to hold till maturity. Obviously, equity shares cannot be included in this account, as they have no maturity. For all other assets held in this account, the amortised cost or historical method is used.
An asset is classified as an available-for-sale asset account if the institution lacks the ability to hold it till maturity or plans to sell it before maturity. An asset is classified as an held-for-trading account, if the asset is acquired with a view to earning a short-term trading profit from market movements. For assets held in available for sale account as well as held-for-trading account, market value accounting is used.
Institutional investors are typically subject to regulations. For examples, banks are regulated by the Reserve Bank of India and insurance companies are regulated by the Insurance Regulatory and Development and Authority. Institutional investors are required to provide to regulators financial reports prepared according to regulatory accounting principles (RAP). RAP may not be fully congruous with GAAP. The surplus as measured by RAP accounting is referred to as regulatory surplus.
Characteristics of Investment Management
Investment management business has the following characteristics:1.It is very easy to get into the business of investment management, assuming that the regulatory requirements are met.2.A market share beyond some level appears to be detrimental to product quality.3.Diminishing returns from scale seem to set in rather early.4.Investment management business is highly sensitive to exogenous economic forces.5.Many talented academics argue that he worth of investment management is zero: They are right in the sense that one-half of the money managed by investment management firms will perform below average.
Institutional Investors
The major institutional investors are
• Insurance companies
• Banks
• Pension funds
• Endowment funds
• Investment companies
Life Insurance Companies
Life insurance companies write a variety of policies, the more
important ones being the endowment assurance plan, money back plan,
whole life assurance plan, unit linked insurance plan, and term assurance
plan. In addition, life insurance companies sell annuity products.
The liabilities of a life insurance company are defined by the
policies it writes and the annuity products it sells. Obviously, life insurance
companies invest so as to hedge their liabilities. Given the nature of their
liabilities, life insurance companies predominantly invest in government
securities. The investment guidelines issued by regulatory authorities also
prescribe such a pattern of investment.
Banks
The principal liabilities of banks are in the form of accounts of
depositors. The cost of deposits is more for fixed deposits of longer tenors
(say two to five years) and less for CASA (current and savings account) –
that is why banks strive to improve their CASA ratio.
Most bank assets are in the form of loans and advances to
businesses and individuals. In addition, banks also invest a fair proportion
of their assets (25 to 30 percent or so) in government bonds and other
securities, largely to fulfill certain statutory requirements. Banks try to
match the risk of assets to liabilities while maintaining a healthy spread
between the lending and borrowing rates.
Pension Funds
The two basic types of pension plans are defined contribution plans and defined benefit plans. Defined contribution plans are essentially savings accounts established by the firm for its employees. While the employer contributes funds to the plan, the employee assumes the risk of the fund’s investment performance. Under these plans, the obligation of the firm is limited to making the stipulated contributions to the retirement account of the employee. The employee has the discretion of choosing among several investment funds (or schemes) in which the assets can be placed.
By contrast, in defined benefit plans the firm (employer) is obliged to provide a specified annual retirement benefit to its employees. The benefit is determined by a formula which takes into account the level of salary and the years of service. The payments represent the obligation of the employer, and the assets in the pension fund serve as a collateral for the promised benefits. The risk of the fund’s investment performance is borne by the employer. Should the investment performance of the fund be poor, the firm has an obligation to make good the shortfall by contributing more to the fund.
Pension Funds
The amount the firm must contribute regularly to the fund to meet
its liabilities is computed by a pension actuary on the basis of the
rate of return the fund will earn on its assets. If the actual rate of
return exceeds the assumed rate, the shareholders of the sponsoring
firm gain because the excess return can be used to lower future
contributions. But if the actual rate of return is less than the
assumed rate, the firm will have to increase future contributions.
Since the sponsoring firm’s shareholders assume the risk of a
defined benefit pension plan, the objective of the plan must be
consistent with the objective of the firm’s shareholders.
Endowment Funds
Endowment funds are held by organisations that are mandated to
use their money for specific non-profit purposes. They are financed
by contributions from one or more sponsors, and generally managed
by charitable, educational, and cultural organisations or by
independent foundations created solely to carry out the specific
purposes of the fund. Typically, the investment objective of an
endowment fund is to generate a steady flow of income without
much risk. Hence, the investment portfolio of the firm should
subserve this objective.
Non-Life Insurance Companies
Non-life insurance companies, also called property and casualty insurance companies, (P&C companies) provide a broad range of insurance protection against (i) loss, damage, or destruction of property, (ii) loss or impairment of earning capacity, (iii) claims for damages claimed by third parties on account of alleged negligence, and (iv) loss caused by injury or death due to occupational accidents. As compensation they receive premiums.
Generally, the liabilities of P&C companies are shorter than for life insurance companies and vary with the type of policy, while the timing and amount of any liability remains unknown. Since P&C liabilities are not interest rate sensitive, P&C companies, compared to life insurance companies, tend to invest a higher proportion of their funds in equities.
Portfolio Management Service
• Discretionary schemes
• Non-discretionary schemes
Differences Between PMS and Mutual Funds
• Minimum Investment
• Lock-in-Period
• Exit Load
• Fees
• Interaction with the Scheme Manager
• Customisation
• Transparency
• Taxation
• Information Availability
Hedge Funds
Hedge funds, like mutual funds, are vehicles of collective investment. However, there are some important differences between the two:
• While mutual funds are open to the general investing public,
hedge funds are typically open only to wealthy individuals
and Institutional investors.
• Mutual funds are heavily regulated entities, whereas hedge
funds are only lightly regulated.
• Hedge fund managers can engage in leverage, short sales,
and heavy use of derivatives across various markets, whereas
mutual fund managers cannot.
Three Errors of the Investment Management Industry
1. Falsely defined mission
2. Incorrect ordering of priorities
3. Lack of rigour in counseling
Summary • In recent decades the role and importance of professional asset management and institutional money management has grown significantly.
• Instead of managing your money yourself, you can entrust your money to a professional manager. Availing the services of a professional money manager may involve (a) establishing a private account with an investment advisor or (b) buying shares of an established security portfolio which is managed by an investment company.
• The major institutional investors are insurance companies, banks, pension funds, endowment companies, and investment companies. The nature of liabilities differs from institution to institution and therefore is the key determinant of the asset mix to be included in the portfolio.
• The primary goals of a financial institution are to earn an adequate return on funds invested and maintain a comfortable surplus of assets in excess of liabilities. Three types of surpluses may be calculated by institutions: economic surplus, accounting surplus, and regulatory surplus.
• Financial securities held by institutional investors are classified into three categories: (a) held-to-maturity, (b) available for sale, and (c) held for trading.
• Typically, hedge funds seek to exploit transient misalignments in security valuations. They buy securities that appear to be relatively underpriced and sell securities that appear to be relatively overpriced.
• Hedge funds pursue a wide range of strategies, the more popular ones being the following: equity – based strategies, arbitrage – based strategies, and opportunistic strategies.
•