Level III Review, Institutional Portfolio Management

Study session five in the Level III CFA Program curriculum covers Portfolio Management for Institutional Investors (reading 15-17). You are guaranteed to see an essay question on the material so make sure you devote some time to studying and work through the questions on the previous exams.
The fact that you need to learn the material from the perspective of five different institution types makes it slightly harder than the individual portfolio management section but it’s still easily within reach.
Managing Institutional Investor Portfolios
As with individual portfolios, the focus here is on the IPS components (risk, return and the five constraints) and how they differ for each institutional type.

  • Pensions have an income need with current retirees or an older workforce and a capital gains need for sustainability and a younger workforce. Liquidity and the need/desire to decrease future contributions will also factor
  • Foundations may have a payout requirement and but generally no contractually obligated requirement. Endowments need to meet spending plans for their university or beneficiary. Both should have a total return approach.
  • Insurance companies may differ slightly whether it is life or non-life but generally seek returns for spread management or reduce premiums
  • Banks return requirement is usually determined be the cost of funds and the rate spread

Risk Tolerance

  • Pensions tolerance depends on the age of workforce and time horizon, surplus on pension, and the company’s balance sheet strength
  • Foundations and endowments generally have a relatively high risk tolerance due to infinite life and spending needs relative to total budget
  • Insurance companies have low tolerances and are often Asset-Liability Managed
  • Banks have low tolerances due to high liquidity needs and are often Asset-Liability Managed

Time Horizon

  • Institutionals normally have very long time horizons (increasing risk tolerance) due to corporate nature. Insurance companies have shorter horizons depending on actuarial needs of claims. Banks tend to have shorter horizons due to shorter-term liabilities.

Unique Circumstances

  • These are more rare and will be stipulated in the vignette. Look for moral/ethical considerations in endowments and foundations.


  • Banks and Insurance companies are taxable entities while pension plans and endowments are not. Foundations may be taxed under a certain structure but it is generally not the case.


  • Pension plan liquidity depends on age of workforce, proportion of retired/active lives and any special payout stipulations.
  • Spending rules are very important and very testable for the foundation/endowments. Make sure you know the methods (simple, rolling and geometric) and how it affects risk tolerance. Liquidity for foundations/endowments is generally low.
  • Liquidity for Insurance companies and banks is paramount and relative to liabilities. This is why the ALM section is important for the two types of institutions.

Legal Considerations

  • Generally not an issue for institutionals. Understand that pensions fall under ERISA and the prudent investor rule governs pensions, foundations and endowments.
  • Insurance and banks are regulated at the state level and must meet regulatory requirements for liquidity

Linking Pension Liabilities to Assets
Understand the difference between an asset only approach and liability-matching. Asset Liability matching involves constructing a portfolio directly relating to the maturity needs of the liabilities.
Be able to match a sample portfolio with different weights in different asset classes to the needs of a plan (i.e. if a plan is indexed for inflation it will need to have some nominal bonds, if growth is needed it will need a higher weight to equities). Level III CFA Program Essay Review: 2010 Question #3″ href=”http://www.finquiz.com/blog/2012/04/11/cfa-level-3-essay-review-2010-question-3/” target=”_blank” rel=”noopener”>Question #3B in 2010 is good practice for this section.
Allocating Shareholder Capital to Pension Plans
The concepts are more important here than the formulas. Make sure you understand how the relative allocation to equities or fixed income affects risk and the total asset beta. With a larger allocation to equities, asset risk increases and the beta increases. The company will need to decrease debt financing in the capital structure to keep the company’s equity beta the same.
Understand the effect of including pension assets and liabilities to determine firm WACC and how it affects the operating WACC and allows the firm to take on lower value projects.
Study session six in the Level III CFA Program curriculum covers capital market expectations and is a fairly conceptual reading. Let me know if you have any questions or comments.
‘til then, happy studyin’
Joseph Hogue, CFA

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