You will always have an institutional portfolio management question in the essay portion. Last year’s was worth 26 points (14.4% of morning session and 7.2% of total exam points). I found the readings on institutional a little harder than individual portfolio management but not too bad.
Please download the essay and guideline answers from the CFA Institute’s website here.
With institutional investors you have sections on Pension Plans (mostly about defined benefit), foundations, endowments, insurance companies and banks. Each has their special characteristics though there are points of similarities. Banks and Insurance companies are basically about asset-liability matching while foundations and endowments are about spending needs. We’ll leave the specific points of each to your review of the curriculum or study notes and just address last year’s question here.
Last year’s question had five parts, each with a couple of sub-questions. I read the questions quickly to find out the specific data for which I am looking.
Skimming the questions, we see that we need:
- Return objective- *** Remember, this is an explicit statement of what the investor needs or wants. Just writing out a numerical return percentage won’t cut it. These are easy points, most of the objective will be a cut and paste from within the vignette.
- Calculate a required return- the instructions say SHOW YOUR CALCULATIONS for a reason. Show all steps to make sure you at least get some partial credit.
- Factors in Risk Tolerance
- Liquidity and Time Horizon constraints for the IPS
- Spending rule affect on goals and funding
- More risk tolerance factors
Some notes on endowments & foundations:
- Know the spending rules: volatility/riskiness in funding and why would you choose each
- Difference between endowments/foundations
- Factors for risk tolerance (portion of spending budget for endowments, unlimited time horizon)
i. Most endowments and foundations, unless explicitly stated in vignette, are going to want to maintain REAL VALUE OF ASSETS. This means they must earn a return high enough to satisfy spending needs and inflation.
ii. The Institute will give you points for a geometric or arithmetic return (but we’re all professionals and can do simple multiplication, so use the geometric return).
Required return is going to be = spending rate * inflation rate * management expenses.
* remember- the correct inflation rate is that applicable to spending (this case higher education) not necessarily general inflation
* Know how to calculate your spending rate from the three spending rules
Worth six points: one point for circling the correct answers in middle box, two points for ONE REASON stated in third column. ** Remember– graders are only going to look at your first response. Don’t waste your time putting down more than one response.
The guideline answer shows two possible responses, only one was asked for.
– For endowments, generally as funding increases, risk tolerance increases because spending needs are lower proportion of total assets.
– As inflation increases, risk increases as well because it becomes harder to protect REAL VALUE of assets in portfolio and also satisfy spending needs
Remember TUTLL, IPS constraints are just as important for institutionals as for individuals
Time- will generally be infinite (perpetuity) unless explicit in case
Unique- usually explicit in case as well (endowments and foundations often have prohibitions against investing in ‘vice’ stocks, so Socially-Responsible Investing)
Taxes- Endowments/Foundations are tax exempt, Banks and Insurance are Taxable
Liquidity- Annual spending needs for Endowment/Foundations, Very important for Banks/Insurance
Legal- UMIFA for Endowments/Foundations, Highly-regulated (usually state) banks/Insurance
i. primary goal for endowment is usually spending with protection of real value- reducing portfolio risk will also reduce expected return and make it harder to cover spending and inflation
ii. LEARN THE SPENDING RULES! Three-year average rule will smooth needs thus lowering volatility
Again, ONLY WRITE WHAT IS ASKED FOR. The questions asks for 3 factors (don’t write six and hope the grader will look for the best 3, they don’t do this)
Guideline answer provided by Institute shows 7 possible answers, you only need 3
– Risk tolerance for endowment is highly dependent on proportion of spending needs to total assets
– Spending rule and volatility of spending needs affects risk tolerance greatly
– Look for stability and momentum of funding/donation sources
We’ll cover insurance companies and pensions with the 2010 essay question in a future post. Looking forward to your comments.
Thanks for readin’
Joseph Hogue, CFA
P.S. let me know if you are having a hard time on any particular topic areas and maybe we’ll try to cover them in a post.