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Investment - Asset Allocation and Portfolio Construction
After generating the investment policy statement (IPS), which comprises — among other facts — an investor’s desire and ability to take risk, the asset allocation of the portfolio is defined.
This determination entails decisions regarding whether asset classes are suitable (e.g., global stocks, domestic government bonds, commodities, or domestic real estate investment trusts) and the proportion of the portfolio to invest in each asset class. In some circumstances, the asset distribution decision is documented as part of the IPS; in other cases, asset allocation is recognized as part of the following execution of the IPS.
The chosen strategic asset allocation is intended to match the investor’s long-term risk and return objectives. An investor may determine the strategic asset allocation and simply keep a portfolio for the life of the investment. If the investor does so, the proportions of the portfolio will likely vary from the original weights specified because the different asset classes provide different rates of return over time and their values thus increase or fall by different amounts. As a result, the portfolio has to be changed through a process called rebalancing.
Rebalancing entails selling some of the assets that have increased as a proportion of the portfolio and putting the proceeds into the holdings that have declined as a proportion of the portfolio. Because there are trading costs connected with rebalancing, most investors will not rebalance on a continuing basis, but will instead rebalance at specified intervals or weightings.
Tactical Asset Allocation
Although the chosen strategic asset allocation is expected to match the investor’s objectives over the long term, there are instances when shorter-term changes in asset class returns can be utilized to potentially boost portfolio returns. A short-term change among asset classes is known as tactical asset allocation.
Strategic Asset Allocation
Strategic asset allocation is the long-term mix of assets that is expected to suit the investor’s objectives. The desired overall risk and return profile of the portfolio is a consideration in selecting the strategic asset allocation. A portfolio with a strategic asset allocation dominated by stocks would be expected to have a greater return and be more volatile than a portfolio dominated by bonds because bonds normally have lower risk than equities and so provide lower returns. The strategic asset allocation that is suitable for one investor may not be suitable for another.
Academic research have revealed that strategic asset selection considerably affects the average return of a portfolio. Thus, asset allocation demands considerable attention from investors, investment managers, and investment counselors. Consider the following example of strategic asset allocation.
Example: Strategic Asset Allocation
An institutional investor requires a 7% return on its investments. The investing committee decides to invest in global equities and in European government bonds. At the time the investment is made, European government bonds are yielding 4%, and the committee’s projection for the long-term return on the global equities market is 9%.
A portfolio allocation of 40% bonds and 60% equity generates an estimated return of 7%: (0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7%
The committee has to examine the level of risk suggested by this asset allocation. If the committee is not comfortable with the risk, the return criterion may need to be adjusted. The portfolio composition can be modified as bond yields vary and the committee revises its forecasts for the return on the global equity.
Strategic asset allocation often involves investment managers to evaluate the projected risk and return of each asset type. Historical returns can be used as a guide, but forecasts need to be forward-looking. Managers also need to establish the correlation of returns between the asset classes so they can quantify the diversification benefits that may be realized by combining the various assets in a portfolio.
To illustrate, we will extend the preceding scenario in which an investor has a strategic asset allocation of 60% global equities and 40% European government bonds. The investment manager may think the global equities market is overvalued and likely to provide bad returns in the short run. In response, the manager could modify the asset allocation to, for example, 50% equities and 50% bonds. If the manager’s forecast is true, this 50/50 tactical allocation will perform better in the near term than the strategic asset allocation of 60/40. The management will have added return for the investment compared with maintaining the strategic weights on a static basis.
But anticipating markets is tough, and tactical allocation does not always favor the investor. The difficulty of financial forecasting means investors may prefer to retain their strategic asset allocation within established parameters. For example, an appropriate strategic asset allocation may be judged to be 56%–64% global stocks and 36%–44% European government bonds, rather than 60% global equities and 40% European government bonds. Such ranges allow for some tactical asset allocation and lessen the need for and expense of frequent portfolio rebalance.
An investor or manager often employs a range of tools and information to make tactical allocation decisions. The decisions may be based on one of the following:
Fundamental studies of economic and political factors and their probable effects on market returns
Market value measures relative to prior data
Trends and momentum in marketplaces
When considering tactically adjusting a portfolio’s asset allocation, a manager may look at the strength of the economy and expected future trends to acquire a view on how the central bank might change interest rates and on what might happen to company profits. The manager may next look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges. The management could also look at stock and bond market patterns as a way of measuring investor mood.
Tactical asset allocation represents an attempt to enhance value to a portfolio by departing from the strategic asset allocation. Tactical asset allocation is a form of active portfolio management.
After generating the investment policy statement (IPS), which comprises — among other facts — an investor’s desire and ability to take risk, the asset allocation of the portfolio is defined.
This determination entails decisions regarding whether asset classes are suitable (e.g., global stocks, domestic government bonds, commodities, or domestic real estate investment trusts) and the proportion of the portfolio to invest in each asset class. In some circumstances, the asset distribution decision is documented as part of the IPS; in other cases, asset allocation is recognized as part of the following execution of the IPS.
The chosen strategic asset allocation is intended to match the investor’s long-term risk and return objectives. An investor may determine the strategic asset allocation and simply keep a portfolio for the life of the investment. If the investor does so, the proportions of the portfolio will likely vary from the original weights specified because the different asset classes provide different rates of return over time and their values thus increase or fall by different amounts. As a result, the portfolio has to be changed through a process called rebalancing.
Rebalancing entails selling some of the assets that have increased as a proportion of the portfolio and putting the proceeds into the holdings that have declined as a proportion of the portfolio. Because there are trading costs connected with rebalancing, most investors will not rebalance on a continuing basis, but will instead rebalance at specified intervals or weightings.
Tactical Asset Allocation
Although the chosen strategic asset allocation is expected to match the investor’s objectives over the long term, there are instances when shorter-term changes in asset class returns can be utilized to potentially boost portfolio returns. A short-term change among asset classes is known as tactical asset allocation.
Strategic Asset Allocation
Strategic asset allocation is the long-term mix of assets that is expected to suit the investor’s objectives. The desired overall risk and return profile of the portfolio is a consideration in selecting the strategic asset allocation. A portfolio with a strategic asset allocation dominated by stocks would be expected to have a greater return and be more volatile than a portfolio dominated by bonds because bonds normally have lower risk than equities and so provide lower returns. The strategic asset allocation that is suitable for one investor may not be suitable for another.
Academic research have revealed that strategic asset selection considerably affects the average return of a portfolio. Thus, asset allocation demands considerable attention from investors, investment managers, and investment counselors. Consider the following example of strategic asset allocation.
Example: Strategic Asset Allocation
An institutional investor requires a 7% return on its investments. The investing committee decides to invest in global equities and in European government bonds. At the time the investment is made, European government bonds are yielding 4%, and the committee’s projection for the long-term return on the global equities market is 9%.
A portfolio allocation of 40% bonds and 60% equity generates an estimated return of 7%: (0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7%
The committee has to examine the level of risk suggested by this asset allocation. If the committee is not comfortable with the risk, the return criterion may need to be adjusted. The portfolio composition can be modified as bond yields vary and the committee revises its forecasts for the return on the global equity.
Strategic asset allocation often involves investment managers to evaluate the projected risk and return of each asset type. Historical returns can be used as a guide, but forecasts need to be forward-looking. Managers also need to establish the correlation of returns between the asset classes so they can quantify the diversification benefits that may be realized by combining the various assets in a portfolio.
To illustrate, we will extend the preceding scenario in which an investor has a strategic asset allocation of 60% global equities and 40% European government bonds. The investment manager may think the global equities market is overvalued and likely to provide bad returns in the short run. In response, the manager could modify the asset allocation to, for example, 50% equities and 50% bonds. If the manager’s forecast is true, this 50/50 tactical allocation will perform better in the near term than the strategic asset allocation of 60/40. The management will have added return for the investment compared with maintaining the strategic weights on a static basis.
But anticipating markets is tough, and tactical allocation does not always favor the investor. The difficulty of financial forecasting means investors may prefer to retain their strategic asset allocation within established parameters. For example, an appropriate strategic asset allocation may be judged to be 56%–64% global stocks and 36%–44% European government bonds, rather than 60% global equities and 40% European government bonds. Such ranges allow for some tactical asset allocation and lessen the need for and expense of frequent portfolio rebalance.
An investor or manager often employs a range of tools and information to make tactical allocation decisions. The decisions may be based on one of the following:
Fundamental studies of economic and political factors and their probable effects on market returns
Market value measures relative to prior data
Trends and momentum in marketplaces
When considering tactically adjusting a portfolio’s asset allocation, a manager may look at the strength of the economy and expected future trends to acquire a view on how the central bank might change interest rates and on what might happen to company profits. The manager may next look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges. The management could also look at stock and bond market patterns as a way of measuring investor mood.
Tactical asset allocation represents an attempt to enhance value to a portfolio by departing from the strategic asset allocation. Tactical asset allocation is a form of active portfolio management.
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Investment - Risk and Portfolio Diversification
An investment policy statement (IPS) captures information about a customer and the client’s needs. The IPS provides as a reference to what is demanded of and what is acceptable in the investment portfolio. The IPS helps guide asset allocation — that is, which asset classes and how much of each asset class should be included in the investor’s portfolio.
Academic research have suggested that asset allocation is the most important factor of portfolio return. Most investors — both individual and institutional — keep a broad range of investments rather than a portfolio concentrated in just a few investments. A fundamental reason for this diversity is the need to manage risk, which is congruent with the aphorism to not ‘put all your eggs in one basket’.
Systematic Risk, Specific Risk, and Diversification
How well investment risk is managed is a crucial factor of the success of investment management. Risk occurs when there is uncertainty, implying that a variety of outcomes are possible from a single scenario or activity.
In financial terminology, risk is the potential that the actual realised return on an investment will be something other than the return originally predicted on the investment. There will be instances when the return fails to match an investor’s expectations and times when the return exceeds expectations. Fluctuations in the prices and values of investments (capital gains and losses) represent the risk of investing. Income (e.g., dividends and interest) may also differ from what was expected.
Most investors seek larger returns and reduced risks. That is, people desire better outcomes and more certainty, all other things being equal. The trade-off between risk and return is a key issue in investment management. Typically, the larger the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return.
Systematic and Specific Risk
The returns on investments, such as equities, bonds, and real estate, will be affected by overall economic conditions. Returns will also be affected by issues that are specific to the particular investment.
Systematic risk
The risk caused by general economic conditions is characterized as systemic or market risk since the danger emanates from the wider economic system. For example, if the economy enters a recession, many companies will notice a fall in their revenues and profits.
Specific risk
Risk that is distinctive to a certain firm or investment is variously termed as specific, idiosyncratic, non-systematic, or unsystematic risk. Examples include the positive share price response when a company releases a successful new product (e.g., the Apple iPad) or the negative response to the news that a promising new treatment has failed in trials.
The distinction between systemic and specific risk is essential because the two categories of risk have different implications for investors. Investors can lower specific risk by holding a number of different securities in their portfolios. Holding a variety of securities that are not associated diversifies away specific risk. The amount to which two asset classes (or securities) move together is indicated by the statistical measure of correlation.The stronger the correlation between the returns on asset classes (or securities), the more comparable their price movements will be.
Investors cannot diversify away systematic risk. They can do nothing to minimize systematic risk because all investments will be influenced to some extent by systematic risk — for instance, a recession. Diversifying an equity portfolio by adding alternative forms of investments, such as real estate, will not eliminate systematic risk because rents and real estate values are affected by the same broad economic variables as the stock market.
Because systematic risk cannot be avoided or spread away and because risk is undesirable, investors have to be compensated for taking on systematic risk. More exposure to systemic risk tends to be associated with higher predicted returns over the long run.
Portfolio theory implies that taking on more specific risk does not necessarily lead to higher returns on average because specific risk can be diversified away. But some investors may try to locate shares that they think to outperform (to produce higher returns than predicted based on their risk) and invest in them rather than diversifying. In the process, investors take on specific risk; if they turn out to be correct, they may get a bigger return as a result of taking on more risk.
Diversification
Diversification is one of the most important aspects of investing. When assets and/or asset classes with varied characteristics are mixed in a portfolio, the overall level of risk is often lowered.
Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets. Provided that the two assets are less than completely linked, the risk of the portfolio (measured by the standard deviation of returns) will be smaller than the weighted average of the risk of the two assets individually. Overall, this indicates the risk–return trade-off, which is a key issue for investors, is better for a portfolio of assets than for individual assets.
Most investors have more than two securities in their portfolios. Adding more assets to a portfolio will lower risk through diversification, although eventually the additional benefits begin to lessen. The exhibit below demonstrates the degrees of risk — total, particular, and systematic — for portfolios of shares picked at random from all of the shares in the US market.
Specific risk is decreased by merging additional shares, but as the portfolio moves beyond 30 shares, the incremental risk reduction becomes minimal and the accompanying trading expenses may outweigh any incremental advantage of risk reduction. The display illustrates the ideas of unique risk and diversification. Specific risk is highest at the left side of the exhibit (one share) and lowest at the right side of the display since much of the specific risk is spread away.
Portfolio Risk
The display assumes randomly picked shares. But there is the potential for higher risk reduction when shares with low correlation with each other are chosen.
Combining diverse asset classes can also boost diversification and lower a portfolio’s risk by minimizing specific risk. For example, an investor can combine assets in multiple stock and bond markets with investments in real estate and commodities to lower the overall risk of a portfolio.
An investment policy statement (IPS) captures information about a customer and the client’s needs. The IPS provides as a reference to what is demanded of and what is acceptable in the investment portfolio. The IPS helps guide asset allocation — that is, which asset classes and how much of each asset class should be included in the investor’s portfolio.
Academic research have suggested that asset allocation is the most important factor of portfolio return. Most investors — both individual and institutional — keep a broad range of investments rather than a portfolio concentrated in just a few investments. A fundamental reason for this diversity is the need to manage risk, which is congruent with the aphorism to not ‘put all your eggs in one basket’.
Systematic Risk, Specific Risk, and Diversification
How well investment risk is managed is a crucial factor of the success of investment management. Risk occurs when there is uncertainty, implying that a variety of outcomes are possible from a single scenario or activity.
In financial terminology, risk is the potential that the actual realised return on an investment will be something other than the return originally predicted on the investment. There will be instances when the return fails to match an investor’s expectations and times when the return exceeds expectations. Fluctuations in the prices and values of investments (capital gains and losses) represent the risk of investing. Income (e.g., dividends and interest) may also differ from what was expected.
Most investors seek larger returns and reduced risks. That is, people desire better outcomes and more certainty, all other things being equal. The trade-off between risk and return is a key issue in investment management. Typically, the larger the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return.
Systematic and Specific Risk
The returns on investments, such as equities, bonds, and real estate, will be affected by overall economic conditions. Returns will also be affected by issues that are specific to the particular investment.
Systematic risk
The risk caused by general economic conditions is characterized as systemic or market risk since the danger emanates from the wider economic system. For example, if the economy enters a recession, many companies will notice a fall in their revenues and profits.
Specific risk
Risk that is distinctive to a certain firm or investment is variously termed as specific, idiosyncratic, non-systematic, or unsystematic risk. Examples include the positive share price response when a company releases a successful new product (e.g., the Apple iPad) or the negative response to the news that a promising new treatment has failed in trials.
The distinction between systemic and specific risk is essential because the two categories of risk have different implications for investors. Investors can lower specific risk by holding a number of different securities in their portfolios. Holding a variety of securities that are not associated diversifies away specific risk. The amount to which two asset classes (or securities) move together is indicated by the statistical measure of correlation.The stronger the correlation between the returns on asset classes (or securities), the more comparable their price movements will be.
Investors cannot diversify away systematic risk. They can do nothing to minimize systematic risk because all investments will be influenced to some extent by systematic risk — for instance, a recession. Diversifying an equity portfolio by adding alternative forms of investments, such as real estate, will not eliminate systematic risk because rents and real estate values are affected by the same broad economic variables as the stock market.
Because systematic risk cannot be avoided or spread away and because risk is undesirable, investors have to be compensated for taking on systematic risk. More exposure to systemic risk tends to be associated with higher predicted returns over the long run.
Portfolio theory implies that taking on more specific risk does not necessarily lead to higher returns on average because specific risk can be diversified away. But some investors may try to locate shares that they think to outperform (to produce higher returns than predicted based on their risk) and invest in them rather than diversifying. In the process, investors take on specific risk; if they turn out to be correct, they may get a bigger return as a result of taking on more risk.
Diversification
Diversification is one of the most important aspects of investing. When assets and/or asset classes with varied characteristics are mixed in a portfolio, the overall level of risk is often lowered.
Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets. Provided that the two assets are less than completely linked, the risk of the portfolio (measured by the standard deviation of returns) will be smaller than the weighted average of the risk of the two assets individually. Overall, this indicates the risk–return trade-off, which is a key issue for investors, is better for a portfolio of assets than for individual assets.
Most investors have more than two securities in their portfolios. Adding more assets to a portfolio will lower risk through diversification, although eventually the additional benefits begin to lessen. The exhibit below demonstrates the degrees of risk — total, particular, and systematic — for portfolios of shares picked at random from all of the shares in the US market.
Specific risk is decreased by merging additional shares, but as the portfolio moves beyond 30 shares, the incremental risk reduction becomes minimal and the accompanying trading expenses may outweigh any incremental advantage of risk reduction. The display illustrates the ideas of unique risk and diversification. Specific risk is highest at the left side of the exhibit (one share) and lowest at the right side of the display since much of the specific risk is spread away.
Portfolio Risk
The display assumes randomly picked shares. But there is the potential for higher risk reduction when shares with low correlation with each other are chosen.
Combining diverse asset classes can also boost diversification and lower a portfolio’s risk by minimizing specific risk. For example, an investor can combine assets in multiple stock and bond markets with investments in real estate and commodities to lower the overall risk of a portfolio.
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Investment - Investment Policy Statements
It is good practice to record information about the client and the client’s needs in an investment policy statement (IPS). An IPS, for both individual and institutional investors, acts as a guide for the investor and investment manager or adviser regarding what is required of and acceptable in the investment portfolio. An IPS also forms the basis for establishing what constitutes success in managing the portfolio.
The IPS should incorporate the investor’s objectives and any limits that will apply to the portfolio. The investor and manager/adviser should agree on the IPS and evaluate it on a regular basis, often once a year. It should also be revisited when the client encounters a change in circumstances. Creating and revising an IPS is a wonderful opportunity for the investment manager and client to discuss the client’s goals.
A common format for an IPS is to split it into sections covering objectives and restrictions. Each section has its own subsections. The IPS identifies the investor’s conditions and ambitions within the categories of needs and differences described in this course.
Objectives
Return requirement
Risk tolerance
Constraints
Time horizon Liquidity
Regulatory restrictions
Taxes
Unique conditions
A standard IPS comprises objectives and restrictions, but many investors, especially institutional investors, may additionally include procedural and governance issues in the IPS.
The IPS may spell out the role of an investment committee along with its organization and its jurisdiction. It may also lay out the functions of investment managers along with the grounds on which they will be appointed and the criteria on which they will be assessed.
An important aspect of the IPS is to give information that is valuable in determining the types and amounts of assets in which to invest and the way the portfolio will be managed over time.
So, the IPS serves as the basis for developing the optimal portfolio strategies and asset allocations.
Institutional Investors and the Investment Policy Statement
Most institutional investors design and employ a thorough IPS. These statements specify several of the following points:
The overall aims (including return objectives) of the investment strategy and its relevance to the mission of the institution
The risk tolerance of the organisation and its capability for carrying risk
All economic and operational constraints, such as tax concerns, legal and regulatory circumstances, and any other particular requirements
The time horizon over which funds are to be invested
The relative importance of capital preservation and capital growth
The asset types in which the institution is allowed to invest
A target asset allocation that states what proportion of the investment funds will be invested in each asset class
Whether leverage (use of debt) or short positions are authorized
How actively the institution will trade
How investment decisions will be made
The benchmarks against which the institution will measure total investment returns
After the IPS is prepared and required points addressed, the board of the institution or its senior leadership formally accepts the investment and payout policies.
The investment leaders then select whether to handle investments in-house or to contract with one or more investment managers.
Institutional investors that handle their investments in-house hire a team of investment specialists to manage their investments.
Institutional investors who hire outside investment managers may use one manager to oversee all investments or numerous managers. Institutional investors generally use numerous managers to lessen the risk of considerable loss as a result of poor performance by any one manager. Many institutional investors utilize distinct managers for each asset class in which they invest.
By engaging managers who specialise in particular asset classes, the institutional investors receive investment experience and access to investments that a generalist might not have.
It is good practice to record information about the client and the client’s needs in an investment policy statement (IPS). An IPS, for both individual and institutional investors, acts as a guide for the investor and investment manager or adviser regarding what is required of and acceptable in the investment portfolio. An IPS also forms the basis for establishing what constitutes success in managing the portfolio.
The IPS should incorporate the investor’s objectives and any limits that will apply to the portfolio. The investor and manager/adviser should agree on the IPS and evaluate it on a regular basis, often once a year. It should also be revisited when the client encounters a change in circumstances. Creating and revising an IPS is a wonderful opportunity for the investment manager and client to discuss the client’s goals.
A common format for an IPS is to split it into sections covering objectives and restrictions. Each section has its own subsections. The IPS identifies the investor’s conditions and ambitions within the categories of needs and differences described in this course.
Objectives
Return requirement
Risk tolerance
Constraints
Time horizon Liquidity
Regulatory restrictions
Taxes
Unique conditions
A standard IPS comprises objectives and restrictions, but many investors, especially institutional investors, may additionally include procedural and governance issues in the IPS.
The IPS may spell out the role of an investment committee along with its organization and its jurisdiction. It may also lay out the functions of investment managers along with the grounds on which they will be appointed and the criteria on which they will be assessed.
An important aspect of the IPS is to give information that is valuable in determining the types and amounts of assets in which to invest and the way the portfolio will be managed over time.
So, the IPS serves as the basis for developing the optimal portfolio strategies and asset allocations.
Institutional Investors and the Investment Policy Statement
Most institutional investors design and employ a thorough IPS. These statements specify several of the following points:
The overall aims (including return objectives) of the investment strategy and its relevance to the mission of the institution
The risk tolerance of the organisation and its capability for carrying risk
All economic and operational constraints, such as tax concerns, legal and regulatory circumstances, and any other particular requirements
The time horizon over which funds are to be invested
The relative importance of capital preservation and capital growth
The asset types in which the institution is allowed to invest
A target asset allocation that states what proportion of the investment funds will be invested in each asset class
Whether leverage (use of debt) or short positions are authorized
How actively the institution will trade
How investment decisions will be made
The benchmarks against which the institution will measure total investment returns
After the IPS is prepared and required points addressed, the board of the institution or its senior leadership formally accepts the investment and payout policies.
The investment leaders then select whether to handle investments in-house or to contract with one or more investment managers.
Institutional investors that handle their investments in-house hire a team of investment specialists to manage their investments.
Institutional investors who hire outside investment managers may use one manager to oversee all investments or numerous managers. Institutional investors generally use numerous managers to lessen the risk of considerable loss as a result of poor performance by any one manager. Many institutional investors utilize distinct managers for each asset class in which they invest.
By engaging managers who specialise in particular asset classes, the institutional investors receive investment experience and access to investments that a generalist might not have.
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Investment - Factors that Affect Investors' Needs
Investors — whether individual or institutional — have distinct investment objectives. Key factors that are universal to all investors, but that will vary in amplitude for each investor, include the following:
Required return
Risk tolerance
Time horizon
Investors may also have distinct needs in relation to liquidity, tax concerns, regulatory necessity, compatibility with particular religious or ethical standards, or other unique conditions. Investors’ situations and needs change over time, therefore it is vital to re-evaluate their needs at least annually.
Required Return
Investors differ in how much return they need to accomplish their aims. The rate of return required, before and after tax, can be estimated using some aim for future wealth or portfolio value.
For example, depending on an investor’s age, initial investable assets, planned savings, and tax situation, an adviser may calculate that a 6% rate of return before tax on investments is required for the investor to reach his or her goal of having a EUR500,000 portfolio value at retirement.
If the desired rate of return seems unlikely to be obtained, the investor’s goals may have to be updated or other criteria, such as the quantity of savings, may have to be adjusted.
An investor may use a total-return perspective, which sees no distinction between income (for example, dividends and interest) and capital gains (i.e., rises in market value). The source of return — changes in value or income — does not matter to a total-return-oriented investor. Alternatively, an investor may discriminate between income and capital gains, seeking income for present consumption and capital gains for long-term requirements.
The return criterion, particularly for a long-term horizon, should be defined in real terms, which involves compensating for the effect of inflation. This modification is vital because it preserves the emphasis on what the accumulating portfolio will give at the conclusion of the time horizon. An increase in value that simply equals inflation does not give a client more spending power.
The investment manager or adviser has to be comfortable that the investor’s targeted rate of return is possible within the related limits. Most clients would desire high returns with little risks, but few investments offer this expected profile. The adviser or manager has a role in counselling the customer.
Typically, higher levels of expected return will require higher amounts of risk to be taken.
Some investors will prefer to invest in hazardous assets because they require high levels of return to fulfill their goals, but the potential implications (the negative risks) connected with this strategy need to be addressed.
Other investors will have previously collected sufficient assets that they do not require significant returns to fulfill their goals and can choose a lower-risk approach. This condition could be the case for a pension plan that has a high funding level, indicating that its assets are adequate, or almost sufficient, to satisfy its liabilities.
Other individuals that have gathered considerable assets may choose to invest in riskier assets since they are capable of absorbing the risk and are able to fulfill their goals even if they experience losses.
Investors, particularly individual investors, will frequently modify the proportion they invest in different kinds of assets over time as they age and their circumstances change. Individual investors with defined contribution pension plans can also alter their investments inside the defined contribution plan.
Risk Tolerance
Investors often have restrictions on how much risk they are willing and able to take with their investments. As discussed earlier, there is a connection between risk and return. Typically, the bigger the predicted return, the higher the risk connected with that return. Equally, the more risk taken, the bigger the projected reward. The investor’s risk tolerance is a result of their ability and willingness to take risk.
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The ability to assume risk relies on the condition of the investor, such as the balance between assets and obligations and the time horizon. If individual investors have significantly more assets than liabilities, any losses that occur from risk taking may not impact their lifestyle. If investors have a lengthy time horizon, they have more freedom to adapt their circumstances to cope with losses by saving more or waiting for markets to rebound, although recovery and its timing cannot be assured.
Willingness to take risk is tied to the investor’s psychology, which may be examined using questionnaires. desire to take risk is frequently considered of as a more relevant issue for individual investors, but even those who oversee institutional investments will have risk guidelines within which they must work and that help define their ability and desire to take risk.
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Some institutional investors, such as insurance companies and other financial intermediaries, may also face regulatory constraints on how much risk they can take with their holdings.
There may be scenarios in which an individual investor’s willingness to accept risk and their ability to take risk diverge. In such cases, the investment adviser should counsel the investor on risk and assess the right level of risk to take in the portfolio, taking into account both the investor’s ability and willingness to take risk. The lowest of the two risk levels should be the risk level adopted.
Time Horizon
The investor and adviser must be clear on the time horizon for the investments. Some investors will need to access money from their portfolios in the immediate term, but others will have a much longer time horizon.
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On the institutional side, for example, a property and casualty insurance company that expects to have to meet claims in the next few years will have a short time horizon, whereas a sovereign wealth fund that is investing oil revenues for the benefit of future generations will have a long time horizon, possibly decades.
Someone who is intending on buying new house, new automobile or paying for education in two or three years would have a short horizon which is a fraction of his investment.
A 20 years old investing for retirement will have a lengthy horizon and mehr than 40 years.
The investment horizon has crucial consequences for how much risk can be taken with the portfolio and the level of liquidity that may be necessary. Liquidity is the ease with which the investment can be converted into cash. For example, an illiquid private equity investment with an anticipated payout in 10 years would be unsuitable for an investor with a 5-year investment horizon.
Both institutions and people must also consider longevity risk, which refers to the potential that life expectancy surpasses expectations and resulting in greater-than-expected cash flow needs in the future.
INDIVIDUAL LONGEVITY RISK
Individuals planning for retirement face the risk of outliving their assets.
INSTITUTIONAL LONGEVITY RISK
Institutions, such as pension funds and insurance firms, are exposed to high longevity risk when guaranteeing guaranteed lifetime payments. As medicine develops and wealth levels rise, longevity risks will increase and induce more adoption of risk mitigation techniques (e.g., expenditure modifications, insurance risk pooling) among individuals and institutions
Investors with longer time horizons should be able to assume greater risk since they have more time to adapt to their circumstances. For example, they can save extra to compensate for any losses or returns that are less than projected.
History shows that, over time, markets go up more often than they go down, thus an investor with a longer time horizon has greater chance to build good return performance.
Longer-term investors are also better equipped to wait for markets to rebound from a period of bad performance, but recovery cannot be guaranteed.
Liquidity
Investors vary in the amount to which they may need to remove money from their holdings. They may need to make a withdrawal to fund a specific purchase or to build a monthly revenue stream. These needs have ramifications for the types of investments chosen. When liquidity is required, the investments will need to be convertible to cash relatively fast and without too much expense (keeping transaction costs and variations in price low) when the cash is needed.
Individual Investors
An person may require that a portion of the portfolio be liquid to pay unanticipated needs. In addition, the individual may have known future liquidity requirements, such as an anticipated future expenditure on children’s schooling or retirement income demands.
Institutional Investors
For an institution, the liquidity restriction often reflects the institution’s liabilities. For example, a pension fund may expect to begin suffering net cash withdrawals at a given time in the future (i.e., when pension payments exceed new contributions to the plan) and will need to sell off some portfolio investments to fulfill those demands. It needs to hold liquid assets in order to do this.
Regulatory Issues
Some sorts of investors have regulatory restrictions that apply to their investments.
For example, in some countries and for certain types of institutional investors, there are restrictions on the proportion of the portfolio that can be invested overseas or in riskier assets, such as shares. Regulations on the holdings of insurance companies are often substantial to protect policy holders.
Taxes
The tax situations of investors differ. Some categories of investors are taxed on their investment returns, and others are not. For example, in many nations, pension funds are excluded from tax on investment returns. Furthermore, the tax treatment of income and capital gains can differ. It is crucial for investment advisers to evaluate an investor’s tax situation and the tax repercussions of alternative investments.
Investors should care about the profits they make after taxes and fees since that is what is available to spend. For example, an investor who is subject to higher tax on dividend income than capital gains will normally choose a portfolio of assets targeting capital growth (i.e., from an increase in value of shares) rather than income (i.e., dividends from shares).
Individuals may also face various tax circumstances for different components of their wealth.
For example, an individual may opt to maintain some assets in a pension account if income and capital gains on assets held in a pension account are tax-exempt or tax-deferred. The investor may choose to hold assets expected to generate capital gains in a taxable investment account if capital gains are taxed at a lower rate than income. Where assets are held can considerably affect an investor’s after-tax profits and wealth building.
Unique Circumstances
Many investors have special requirements or limits not reflected by the traditional categories addressed thus far.
Some investors evaluate how environmental, social, and governance concerns (together known as ESG investing) impact the financial performance of possible investments. Beyond assessing ESG risks associated with an investment, some investors expressly pursue an impact investing approach, which targets investments having beneficial and measurable societal or environmental outcomes (e.g., using social or environmental measures).
Some other investors directly incorporate religious or ethical preferences and exclusions into their investment preferences. For example, some investors may not participate in traditional debt securities because they do not believe they accord with Islamic law.
Investors may also have special requirements that come from the type of their broader investment portfolio or financial circumstances. For example, an individual who is employed by a corporation may seek to limit investment in that company. Limiting investment in securities issued by their workplace would help the employee reduce single-company risk and acquire broader diversification.
Interestingly, many individuals are actually tempted to expand their holdings in their employers’ shares on the grounds of loyalty or familiarity, despite the danger that this strategy carries. Such a strategy can have significant ramifications if the company fails or its financial position falls. For example, many employees of Enron Corporation, a US energy corporation, not only lost their employment but also suffered huge investment losses when Enron went bankrupt.
Institutional investors may also have unique and specific criteria as a result of their objectives and circumstances. For example, a medical foundation may desire to avoid investing in tobacco stocks because it considers encouraging tobacco smoking is antithetical to its objectives of improving health.
Behavioural Finance Considerations
Behavioural finance aims to understand and explain actual investor behaviour, in contrast to theorising about investor behaviour. It varies from traditional (or standard) finance, which is founded on assumptions of how investors and markets should behave. Behavioural finance is about understanding how individuals make decisions, both individually and collectively.
By understanding how investors and markets behave, it may be able to adjust or adapt to these behaviours in order to enhance investment outcomes. In other words, the way investors think and feel affects the way they behave while making investing decisions. Some of these actions are implicitly impacted by prior experiences and personal beliefs to the extent that even competent investors can break from logic and reason.
These factors, which can be classified and characterized as behavioural biases, can alter the way risk is seen and how risk is understood by someone trying to determine a person’s risk tolerance.
Examples of behavioral biases that effect investment decision making vary by individual and institution and are often classed as either emotional or cognitive biases.
EMOTIONAL BIAS
Emotional biases come from instinct or intuition and tend to result from reasoning impacted by feelings.
Example: Loss Aversion Bias
Investors tend to feel the agony of losses more than the pleasure of wins compared with other client categories. Thus, these investors may hold on to failing investments too long, even when they see little hope of a recovery.
COGNITIVE BIAS
Cognitive biases come from basic statistical, information-processing, or memory problems; cognitive errors often result from erroneous reasoning.
Example: Hindsight Bias
Some investors may be prone to hindsight bias, which happens when an investor interprets prior investment outcomes as if they had been predicted. Investment outcomes are rarely, if ever, predicted.
An example of hindsight bias is the response by investors to the financial crisis of 2008. Initially, many saw the housing market’s performance from 2003 to 2007 as ‘normal’ (i.e., not suggestive of a bubble). It was only later that many said, ‘was it not obvious?’ when the market experienced a catastrophe in 2008. Hindsight bias offers investors a false sense of security when making investing decisions, emboldening them to assume excessive risk without perceiving it as such.
Investors — whether individual or institutional — have distinct investment objectives. Key factors that are universal to all investors, but that will vary in amplitude for each investor, include the following:
Required return
Risk tolerance
Time horizon
Investors may also have distinct needs in relation to liquidity, tax concerns, regulatory necessity, compatibility with particular religious or ethical standards, or other unique conditions. Investors’ situations and needs change over time, therefore it is vital to re-evaluate their needs at least annually.
Required Return
Investors differ in how much return they need to accomplish their aims. The rate of return required, before and after tax, can be estimated using some aim for future wealth or portfolio value.
For example, depending on an investor’s age, initial investable assets, planned savings, and tax situation, an adviser may calculate that a 6% rate of return before tax on investments is required for the investor to reach his or her goal of having a EUR500,000 portfolio value at retirement.
If the desired rate of return seems unlikely to be obtained, the investor’s goals may have to be updated or other criteria, such as the quantity of savings, may have to be adjusted.
An investor may use a total-return perspective, which sees no distinction between income (for example, dividends and interest) and capital gains (i.e., rises in market value). The source of return — changes in value or income — does not matter to a total-return-oriented investor. Alternatively, an investor may discriminate between income and capital gains, seeking income for present consumption and capital gains for long-term requirements.
The return criterion, particularly for a long-term horizon, should be defined in real terms, which involves compensating for the effect of inflation. This modification is vital because it preserves the emphasis on what the accumulating portfolio will give at the conclusion of the time horizon. An increase in value that simply equals inflation does not give a client more spending power.
The investment manager or adviser has to be comfortable that the investor’s targeted rate of return is possible within the related limits. Most clients would desire high returns with little risks, but few investments offer this expected profile. The adviser or manager has a role in counselling the customer.
Typically, higher levels of expected return will require higher amounts of risk to be taken.
Some investors will prefer to invest in hazardous assets because they require high levels of return to fulfill their goals, but the potential implications (the negative risks) connected with this strategy need to be addressed.
Other investors will have previously collected sufficient assets that they do not require significant returns to fulfill their goals and can choose a lower-risk approach. This condition could be the case for a pension plan that has a high funding level, indicating that its assets are adequate, or almost sufficient, to satisfy its liabilities.
Other individuals that have gathered considerable assets may choose to invest in riskier assets since they are capable of absorbing the risk and are able to fulfill their goals even if they experience losses.
Investors, particularly individual investors, will frequently modify the proportion they invest in different kinds of assets over time as they age and their circumstances change. Individual investors with defined contribution pension plans can also alter their investments inside the defined contribution plan.
Risk Tolerance
Investors often have restrictions on how much risk they are willing and able to take with their investments. As discussed earlier, there is a connection between risk and return. Typically, the bigger the predicted return, the higher the risk connected with that return. Equally, the more risk taken, the bigger the projected reward. The investor’s risk tolerance is a result of their ability and willingness to take risk.
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The ability to assume risk relies on the condition of the investor, such as the balance between assets and obligations and the time horizon. If individual investors have significantly more assets than liabilities, any losses that occur from risk taking may not impact their lifestyle. If investors have a lengthy time horizon, they have more freedom to adapt their circumstances to cope with losses by saving more or waiting for markets to rebound, although recovery and its timing cannot be assured.
Willingness to take risk is tied to the investor’s psychology, which may be examined using questionnaires. desire to take risk is frequently considered of as a more relevant issue for individual investors, but even those who oversee institutional investments will have risk guidelines within which they must work and that help define their ability and desire to take risk.
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Some institutional investors, such as insurance companies and other financial intermediaries, may also face regulatory constraints on how much risk they can take with their holdings.
There may be scenarios in which an individual investor’s willingness to accept risk and their ability to take risk diverge. In such cases, the investment adviser should counsel the investor on risk and assess the right level of risk to take in the portfolio, taking into account both the investor’s ability and willingness to take risk. The lowest of the two risk levels should be the risk level adopted.
Time Horizon
The investor and adviser must be clear on the time horizon for the investments. Some investors will need to access money from their portfolios in the immediate term, but others will have a much longer time horizon.
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On the institutional side, for example, a property and casualty insurance company that expects to have to meet claims in the next few years will have a short time horizon, whereas a sovereign wealth fund that is investing oil revenues for the benefit of future generations will have a long time horizon, possibly decades.
Someone who is intending on buying new house, new automobile or paying for education in two or three years would have a short horizon which is a fraction of his investment.
A 20 years old investing for retirement will have a lengthy horizon and mehr than 40 years.
The investment horizon has crucial consequences for how much risk can be taken with the portfolio and the level of liquidity that may be necessary. Liquidity is the ease with which the investment can be converted into cash. For example, an illiquid private equity investment with an anticipated payout in 10 years would be unsuitable for an investor with a 5-year investment horizon.
Both institutions and people must also consider longevity risk, which refers to the potential that life expectancy surpasses expectations and resulting in greater-than-expected cash flow needs in the future.
INDIVIDUAL LONGEVITY RISK
Individuals planning for retirement face the risk of outliving their assets.
INSTITUTIONAL LONGEVITY RISK
Institutions, such as pension funds and insurance firms, are exposed to high longevity risk when guaranteeing guaranteed lifetime payments. As medicine develops and wealth levels rise, longevity risks will increase and induce more adoption of risk mitigation techniques (e.g., expenditure modifications, insurance risk pooling) among individuals and institutions
Investors with longer time horizons should be able to assume greater risk since they have more time to adapt to their circumstances. For example, they can save extra to compensate for any losses or returns that are less than projected.
History shows that, over time, markets go up more often than they go down, thus an investor with a longer time horizon has greater chance to build good return performance.
Longer-term investors are also better equipped to wait for markets to rebound from a period of bad performance, but recovery cannot be guaranteed.
Liquidity
Investors vary in the amount to which they may need to remove money from their holdings. They may need to make a withdrawal to fund a specific purchase or to build a monthly revenue stream. These needs have ramifications for the types of investments chosen. When liquidity is required, the investments will need to be convertible to cash relatively fast and without too much expense (keeping transaction costs and variations in price low) when the cash is needed.
Individual Investors
An person may require that a portion of the portfolio be liquid to pay unanticipated needs. In addition, the individual may have known future liquidity requirements, such as an anticipated future expenditure on children’s schooling or retirement income demands.
Institutional Investors
For an institution, the liquidity restriction often reflects the institution’s liabilities. For example, a pension fund may expect to begin suffering net cash withdrawals at a given time in the future (i.e., when pension payments exceed new contributions to the plan) and will need to sell off some portfolio investments to fulfill those demands. It needs to hold liquid assets in order to do this.
Regulatory Issues
Some sorts of investors have regulatory restrictions that apply to their investments.
For example, in some countries and for certain types of institutional investors, there are restrictions on the proportion of the portfolio that can be invested overseas or in riskier assets, such as shares. Regulations on the holdings of insurance companies are often substantial to protect policy holders.
Taxes
The tax situations of investors differ. Some categories of investors are taxed on their investment returns, and others are not. For example, in many nations, pension funds are excluded from tax on investment returns. Furthermore, the tax treatment of income and capital gains can differ. It is crucial for investment advisers to evaluate an investor’s tax situation and the tax repercussions of alternative investments.
Investors should care about the profits they make after taxes and fees since that is what is available to spend. For example, an investor who is subject to higher tax on dividend income than capital gains will normally choose a portfolio of assets targeting capital growth (i.e., from an increase in value of shares) rather than income (i.e., dividends from shares).
Individuals may also face various tax circumstances for different components of their wealth.
For example, an individual may opt to maintain some assets in a pension account if income and capital gains on assets held in a pension account are tax-exempt or tax-deferred. The investor may choose to hold assets expected to generate capital gains in a taxable investment account if capital gains are taxed at a lower rate than income. Where assets are held can considerably affect an investor’s after-tax profits and wealth building.
Unique Circumstances
Many investors have special requirements or limits not reflected by the traditional categories addressed thus far.
Some investors evaluate how environmental, social, and governance concerns (together known as ESG investing) impact the financial performance of possible investments. Beyond assessing ESG risks associated with an investment, some investors expressly pursue an impact investing approach, which targets investments having beneficial and measurable societal or environmental outcomes (e.g., using social or environmental measures).
Some other investors directly incorporate religious or ethical preferences and exclusions into their investment preferences. For example, some investors may not participate in traditional debt securities because they do not believe they accord with Islamic law.
Investors may also have special requirements that come from the type of their broader investment portfolio or financial circumstances. For example, an individual who is employed by a corporation may seek to limit investment in that company. Limiting investment in securities issued by their workplace would help the employee reduce single-company risk and acquire broader diversification.
Interestingly, many individuals are actually tempted to expand their holdings in their employers’ shares on the grounds of loyalty or familiarity, despite the danger that this strategy carries. Such a strategy can have significant ramifications if the company fails or its financial position falls. For example, many employees of Enron Corporation, a US energy corporation, not only lost their employment but also suffered huge investment losses when Enron went bankrupt.
Institutional investors may also have unique and specific criteria as a result of their objectives and circumstances. For example, a medical foundation may desire to avoid investing in tobacco stocks because it considers encouraging tobacco smoking is antithetical to its objectives of improving health.
Behavioural Finance Considerations
Behavioural finance aims to understand and explain actual investor behaviour, in contrast to theorising about investor behaviour. It varies from traditional (or standard) finance, which is founded on assumptions of how investors and markets should behave. Behavioural finance is about understanding how individuals make decisions, both individually and collectively.
By understanding how investors and markets behave, it may be able to adjust or adapt to these behaviours in order to enhance investment outcomes. In other words, the way investors think and feel affects the way they behave while making investing decisions. Some of these actions are implicitly impacted by prior experiences and personal beliefs to the extent that even competent investors can break from logic and reason.
These factors, which can be classified and characterized as behavioural biases, can alter the way risk is seen and how risk is understood by someone trying to determine a person’s risk tolerance.
Examples of behavioral biases that effect investment decision making vary by individual and institution and are often classed as either emotional or cognitive biases.
EMOTIONAL BIAS
Emotional biases come from instinct or intuition and tend to result from reasoning impacted by feelings.
Example: Loss Aversion Bias
Investors tend to feel the agony of losses more than the pleasure of wins compared with other client categories. Thus, these investors may hold on to failing investments too long, even when they see little hope of a recovery.
COGNITIVE BIAS
Cognitive biases come from basic statistical, information-processing, or memory problems; cognitive errors often result from erroneous reasoning.
Example: Hindsight Bias
Some investors may be prone to hindsight bias, which happens when an investor interprets prior investment outcomes as if they had been predicted. Investment outcomes are rarely, if ever, predicted.
An example of hindsight bias is the response by investors to the financial crisis of 2008. Initially, many saw the housing market’s performance from 2003 to 2007 as ‘normal’ (i.e., not suggestive of a bubble). It was only later that many said, ‘was it not obvious?’ when the market experienced a catastrophe in 2008. Hindsight bias offers investors a false sense of security when making investing decisions, emboldening them to assume excessive risk without perceiving it as such.
- Published on
Investment - Types and Characteristics of Investors
Introduction to Investor Types
Investors are not a homogeneous group; both individual and institutional investors have diverse features. Clients differ in terms of their financial resources, objectives, personalities, financial expertise, and so on. These variances affect their financial demands, what services they require, and what assets are appropriate for them. Consider the following example:
Elderly customers with significant resources may be highly concerned with estate planning.
Elderly consumers with little resources may be more anxious about outliving their assets.
Thus, a gap in investment returns may have major ramifications for people concerned about outliving their assets but have less impact on those with significant resources.
Investors can own securities, such as shares and bonds, directly, or they can invest in professionally managed funds to acquire market exposure. Investors may choose securities or funds themselves or contact an investment professional to aid in the decision. Investment experts attempt to provide appropriate investment services to fulfill clients’ demands.
The most basic distinction among investors is that between individual and institutional investors.
INDIVIDUAL INVESTORS
Individual investors trade (buy or sell) securities or permit others to trade stocks for their personal accounts.
INSTITUTIONAL INVESTORS
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others.
The traits that distinguish individual investors are frequently distinct from those that define institutional investors.
Individual Investors
Individual investors are often differentiated based on their resources. The word ‘retail investor’ can be used to refer to all individual investors, although it is typical to use the term to refer to individual investors with little resources to invest. Many investing businesses create a distinction between their regular clients, more affluent clients with higher amounts to invest, and high- and ultra-high-net-worth investors, who have the biggest amounts of investable assets.
The services supplied by investment businesses and the investments available will often vary by the amount of money the client has to invest. Some specialist funds may need minimum quantities of investment (e.g., USD1 million), and some portfolio management services may have minimum costs, rendering them uneconomical for lesser account sizes.
An investment firm that focuses on retail investors has to satisfy the needs of a large number of relatively modest accounts. Doing so often implies consolidating the retail investors’ assets into a smaller number of funds and establishing automated systems for the administration of client fund holdings.
An investment firm or division within an investment firm specializing on high-net-worth investors may have fewer clients, but greater average account balances, than one that concentrates on regular investors. Investor assets may still be placed in funds, however some high-net-worth investors will prefer their own segregated accounts (known as separately managed accounts). Wealthy clients may have higher expectations of client service than retail consumers, and usually the services that are delivered to them are more individualized.
Individual investors vary in their level of investment knowledge and competence. Some individual investors have very limited investment knowledge and competence, and others are more knowledgeable, maybe as a result of their schooling or work experience.
Because individual investors are typically viewed of as less knowledgeable and less experienced than institutional investors, regulators in many countries try to safeguard them by setting restrictions on the assets that can be sold to them.
For example, as of 2022 in the United States, the Securities and Exchange Commission (SEC) restricts investing in some alternative investments to accredited individuals. An individual qualifies as an accredited investor if they have earned income of USD200,000 or more in each of the prior two years and has a reasonable expectation to earn at least USD200,000 in the current year, or has (alone or together with a spouse) a net worth (excluding his or her primary residence) greater than USD1 million.
This restriction is based on the assumption that wealthier investors are anticipated to have a higher level of investing expertise — or access to professional investment counsel — and possess a greater ability to forgo investment liquidity.
Additional variables of the personal situations of individual investors, such as age and family obligations, may also differ and affect their investing demands and decision making. The planned holding term (time or investment horizon) for investments, risk tolerance, and other conditions also affect investors’ needs.
Retail Investors
The investing sector delivers primarily standardised services to retail investors because they make the least money per investor for investment firms. Many retail investing services are supplied online or by customer service personnel working at call centres.
High-Net-Worth Investors
Wealthier investors often receive more personal attention from financial experts. Their investment problems sometimes involve tax and estate planning complications that demand greater resources and professional knowledge. They either pay directly for these services on a fee-for-service basis or indirectly through commissions and other transaction charges.
Ultra-High-Net-Worth Investors and Family Offices
Very affluent individuals generally employ professionals who help them manage their money, future estates, and legal concerns. These specialists generally operate in a family office, which is a private corporation that administers the financial affairs of one or more members of a family or of numerous families.
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Many family offices serve the heirs of huge family fortunes that have been acquired over generations. In addition to investing services, family offices may provide personal services to the family members, such as bookkeeping, tax planning, managing household personnel, making travel arrangements, and coordinating social events.
Wealthy families generally have huge real estate holdings and large financial portfolios. The investment professionals who work in family offices often handle these investments using the same strategies and processes that institutional investors use. They pay especially close attention to personal and estate tax issues that may considerably affect the family’s wealth and their capacity to transfer money on to future generations or charity institutions.
Institutional Investors
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others. There are numerous different sorts of institutional investors with differing investment criteria and limits. Institutional investors may invest to promote their mission, or they may invest for others to address the others’ needs. Institutional investors that invest to achieve their missions include the following:
Pension plans
Endowment funds and foundations
Trusts
Governments and sovereign wealth funds
Non-financial companies
Institutional investors that invest to provide financial services to their clients include investment companies, banks, and insurance companies. Some institutional investors handle their investments internally and employ investment specialists whose duty is to select the investments.
Other institutional investors outsource the investing of the portfolio to one or more external investment firms. The choice between internal and external management will frequently be influenced by the size of the institutional investor, with larger institutional investors better able to afford the resources required for internal management.
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Some institutional investors will choose a mixed model, managing some assets domestically in which they have competence and outsourcing more specialist investments — for example, alternative investments — to external managers. Those institutional investors that choose to outsource investment management still have significant decisions to make in terms of which managers to choose. They may use internal expertise to make manager selection decisions, or they may employ a consultant.
Pension Plans
Pension plans hold investment portfolios — that is, pension funds — for the benefit of future and existing retired members, who are called beneficiaries.
A firm or other body may set up a pension plan to provide benefits to its employees. The companies and governments that sponsor these plans are termed pension sponsors or plan sponsors. Money from employer and/or employee contributions is placed away to give income to plan members when they retire. The payments must be invested until the employee retires and receives the retirement benefits.
Pension plans differ by whether they are arranged as defined benefit or defined contribution schemes.
Defined Benefit Pension Plans
Defined benefit pension schemes promise a defined annual sum to their retired participants. The set amount normally fluctuates by member based on such factors as years of service and annual income while working.
Typically, employees do not have the right to collect benefits until they have worked for the company or government for a term set by the pension plan. An employee’s rights are vested (covered by law or contract) once they have worked for that duration.
Defined benefit pension funds, particularly those of government-sponsored schemes, are among the largest institutional investors. Pension funds may invest in equities securities, debt securities, and alternative assets because they often have relatively lengthy time horizons.
As employees retire, new employees are added to the plan. If new employees are not being added to the plan, the temporal horizon of the plan will diminish over time.
In a defined benefit pension plan, the sponsoring employer promises its members (or employees) a defined amount of benefit. For example, it is extremely typical for the company to promise a yearly pension that is a specified proportion of the employee’s final pre-retirement income.
The pension may be adjusted for inflation over time. The employer will pay contributions to the pension fund to honor the promise. Employees may also be asked to donate.
In a defined benefit plan, the employer bears the risk – in this example, that the investments made by the pension fund fail to perform as predicted. If the investments fail to perform as planned, the employer may be obliged to make further contributions to the fund.
But it is likely that pension sponsors will be unable to make the necessary contributions and that beneficiaries would not receive the benefits expected. Defined benefit plans are becoming less widespread around the globe and are being replaced by defined contribution plans.
Euro Pension Fund is the fund for a defined benefit pension plan located in Frankfurt, Germany. The plan sponsor remits money to the fund based on projections of pension benefit commitments compared with pension plan assets. Working members of the plan also pay a portion of their wages to the fund.
It has an asset management team that devises the fund’s strategy and implements it.
Defined Contribution Pension Plans
In a defined contribution pension plan, the pension sponsor normally contributes an agreed-on amount — the defined contribution — to an account set up for each employee.
Employees also often contribute to their own retirement plan accounts, primarily through employee payroll deductions.
The contributions are subsequently invested, generally in funds that the employee chooses from a list of approved funds inside the plan.
The plan gives enough options of funds to allow employees to establish a broadly diversified portfolio. The sponsor often limits the selections to a group of mutual funds sponsored by recognized investment managers. The pension plan sponsor should also guarantee that the costs levied on the funds are appropriate. At retirement, the money that has accumulated in the account is available to the employee.
In defined contribution plans, the member (or employee) takes the risk that the pension account’s investments fail to perform as predicted. This contrasts with defined benefit plans, in which the employer takes the risk.
In defined contribution plans, the employer has no commitment to make further payments if the investments perform poorly. If the retirement fund is less than projected, the employee may have to make do with less retirement income or, maybe, defer retirement.
Because saving enough and choosing the correct investments are very important, defined contribution plan sponsors are increasingly providing financial assistance to their beneficiaries or arranging for financial consultants to help guide members.
In the past, most pension plans were defined benefit pension plans. Because these plans promise defined benefits to their beneficiaries, they are expensive responsibilities for the sponsor (company) and many sponsors no longer offer them. This development explains why defined contribution pension plans are progressively replacing defined benefit plans in most countries.
Endowment Funds and Foundations
Endowment funds and foundations are also big institutional investors in many nations. Endowment funds are long-term funds of nonprofit institutions, such as universities, hospitals, and museums.
These institutions use their endowment monies to provide some services to their students, patients, and supporters. Foundations are grant-making institutions funded by gifts and by the investment income that they earn. Most foundations do not directly provide services. Instead, they fund entities that provide services in such areas as the arts or charities. Foundations often own endowment funds, which invest the foundation’s money.
Endowment funds and foundations often have a charity or philanthropic aim and accept endowments from contributors interested in supporting their activities. In many countries, gifts to these institutions are tax deductible for the donors.
That is, gifts diminish the income on which the donors have to pay taxes. Investment income and capital gains that these organisations get from investing these funds may also be tax-exempt.
Endowment funds are normally meant to remain in perpetuity and, as such, are viewed as very long-term investors. But they are also often mandated to spend annually on the benevolent or philanthropic objective for their existence, therefore money needs to be pulled from their funds.
Many endowment funds and foundations adopt spending criteria; for example, they may set expenditure goals of a percentage range of their assets. Often, their issue resides in combining long-term growth with shorter-term income or cash flow requirements.
Each endowment fund or foundation has its own special circumstances. Some are able to raise money on an ongoing basis, but others are limited from raising more money. Some endowment funds and foundations are mandated to spend a fixed part of the portfolio each year, whilst others have more flexibility to adjust spending.
These discrepancies have significance for how the institutional investor’s assets are invested. An endowment client that is barred from fundraising has to meet its financial needs from income or the sale of assets, whereas an endowment client that has no restriction on fundraising may also raise money to satisfy its financial needs.
Most institutions with endowment funds use professional investment managers to manage the funds. Some manage portions of their money domestically, in some cases through an investment management company that they control.
Governments and Sovereign Wealth Funds
Governments receive money from collecting taxes or selling bonds. When they do not have to spend this money immediately, they frequently invest it.
Some governments have accumulated significant surpluses from selling natural resources that they control or from financing the trade of goods and services. They create sovereign wealth funds to invest these surpluses for the benefit of present and future generations of their citizens.
Sovereign wealth funds often invest in long-term securities and assets. They also may purchase companies. Sovereign wealth funds either manage their investments in-house or engage investment managers to manage their money.
Non-Financial Companies
Analysts typically identify companies as either financial companies or non-financial companies.
Financial Companies
Financial companies include investment companies, banks and other lenders, and insurance organizations. These companies provide financial services to its clientele.
Non-Financial Companies
Non-financial enterprises produce items and non-financial services for their consumers.
These companies invest money that they do not presently require to run their businesses.
The money invested by non-financial companies may be invested short-term, mid-term, or long-term. The corporate treasurer usually controls the short-term investment assets. These assets often comprise cash that the company will need shortly to pay salaries and accounts payable and financial vehicles that are safe and liquid, like demand deposits (checking accounts), money market funds, and short-term debt securities issued by governments or other companies.
Long-term investments are normally managed under the leadership of the chief financial officer or the chief investment officer, if the company has one. firms often invest long term to finance future research, investments, and acquisitions of firms and goods. Companies may invest long term directly, or they may hire investment managers to invest on their behalf.
Some corporations invest directly in the shares and bonds of their suppliers and in the shares of possible merger partners to strengthen their relationships with them. Practitioners term these investments ‘strategic investments’. These types of investments are widespread in Asian countries, such as Japan and South Korea, and in European countries, such as France, Germany, and Italy.
Investment Companies
Investment businesses include mutual funds, hedge funds, and private equity funds. These firms operate exclusively to hold investments on behalf of its owners, partners, or unitholders (units refer to shares and bonds for equity and debt securities, respectively). These companies are called pooled investment vehicles because investors in these organizations pool their money for common management.
Investment companies are handled by experienced investment managers that work for investment management organizations. These management businesses often structure and market the investment companies that they manage and so function as the investment sponsors.
Mutual funds pool the assets of many investors into a single investment vehicle, which is professionally managed and benefits from economies of scale. There are thousands of mutual funds administered by investment management businesses.
Mutual funds are often classed by their investment(s). Investments eligible for inclusion may be strictly or broadly defined and based on categories of assets, geographic area, and so on.
For example, mutual funds may specify that they invest in Chinese equities identified as having growth potential, global equities, long-term investment-grade European corporate bonds, or commodities. The investment management business receives a fee for managing the fund. Although a mutual fund can be viewed as an institutional investor, the phrase ‘mutual fund’ also refers to the investment vehicle, shares of which an individual or institutional investor might hold in a portfolio.
Hedge funds and private equity funds can similarly be considered institutional investors that manage private investment pools and as investment vehicles. They are distinguished by their use of tactics outside the limits of most standard mutual funds (discussed in Course 2, Types and Functioning of Markets).
Insurance Companies
Insurance companies form another key group of institutional investor.
Insurance Companies collect premium from persons and companies they cover. Premium are required by insurance firms to offer insurance coverage for the policyholders.
Some of the premiums are deposited into a reserve fund form which insurance coverage can be paid. The premiums in the reverse funds are invested in broad portfolios of securities and assets that attempt to ensure that adequate money are always available to meet all claims.
Regulations typically impose rules to restrict the types of investments insurance firms can keep.
Insurance firms profit from the income they gain form float which is the amount money they have available to use after receiving premium and before paying claims.
There are two primary sorts of insurance businesses.
PROPERTY AND CASUALTY
Property and casualty insurance firms safeguard their insured from the financial loss caused by such catastrophes as accidents and theft.
Property and casualty insurers have short-term views and generally unpredictable payouts; therefore, they favor shorter-term assets that are more cautious and liquid.
LIFE
Life insurance firms give payments to the policyholder’s beneficiaries in the event the policyholder dies while the insurance coverage is in force.
Life insurers have longer-term time horizons and more predictable payouts and, thus, have more leeway to engage in riskier assets. They frequently invest their reserve funds, which often are extremely big, in stocks, commodities, real estate, and other real assets.
Some insurance firms give both forms of insurance.
nsurance businesses aim to match their investments to their responsibilities. For example, if they intend to make fixed annuity payments in the far future, they may invest in long-term fixed-income securities to match the interest rate risk of their assets to the interest rate risk of their liabilities.
This approach of matching investment assets to liabilities, called asset/liability matching, decreases the risk that the company would fail to fulfill its claims.
Most large insurance companies manage their investments in-house. They also may contract with investment managers to oversee specialty investments in industries, asset classes, or geographical regions where they lack expertise or access.
Investors — both individual and institutional — differ in their financial resources, circumstances, objectives, views, financial skills, and so on. These distinctions determine what services the client requires and what types of investments are appropriate for the client. Therefore, it is crucial to record information about the client and the client’s needs.
Introduction to Investor Types
Investors are not a homogeneous group; both individual and institutional investors have diverse features. Clients differ in terms of their financial resources, objectives, personalities, financial expertise, and so on. These variances affect their financial demands, what services they require, and what assets are appropriate for them. Consider the following example:
Elderly customers with significant resources may be highly concerned with estate planning.
Elderly consumers with little resources may be more anxious about outliving their assets.
Thus, a gap in investment returns may have major ramifications for people concerned about outliving their assets but have less impact on those with significant resources.
Investors can own securities, such as shares and bonds, directly, or they can invest in professionally managed funds to acquire market exposure. Investors may choose securities or funds themselves or contact an investment professional to aid in the decision. Investment experts attempt to provide appropriate investment services to fulfill clients’ demands.
The most basic distinction among investors is that between individual and institutional investors.
INDIVIDUAL INVESTORS
Individual investors trade (buy or sell) securities or permit others to trade stocks for their personal accounts.
INSTITUTIONAL INVESTORS
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others.
The traits that distinguish individual investors are frequently distinct from those that define institutional investors.
Individual Investors
Individual investors are often differentiated based on their resources. The word ‘retail investor’ can be used to refer to all individual investors, although it is typical to use the term to refer to individual investors with little resources to invest. Many investing businesses create a distinction between their regular clients, more affluent clients with higher amounts to invest, and high- and ultra-high-net-worth investors, who have the biggest amounts of investable assets.
The services supplied by investment businesses and the investments available will often vary by the amount of money the client has to invest. Some specialist funds may need minimum quantities of investment (e.g., USD1 million), and some portfolio management services may have minimum costs, rendering them uneconomical for lesser account sizes.
An investment firm that focuses on retail investors has to satisfy the needs of a large number of relatively modest accounts. Doing so often implies consolidating the retail investors’ assets into a smaller number of funds and establishing automated systems for the administration of client fund holdings.
An investment firm or division within an investment firm specializing on high-net-worth investors may have fewer clients, but greater average account balances, than one that concentrates on regular investors. Investor assets may still be placed in funds, however some high-net-worth investors will prefer their own segregated accounts (known as separately managed accounts). Wealthy clients may have higher expectations of client service than retail consumers, and usually the services that are delivered to them are more individualized.
Individual investors vary in their level of investment knowledge and competence. Some individual investors have very limited investment knowledge and competence, and others are more knowledgeable, maybe as a result of their schooling or work experience.
Because individual investors are typically viewed of as less knowledgeable and less experienced than institutional investors, regulators in many countries try to safeguard them by setting restrictions on the assets that can be sold to them.
For example, as of 2022 in the United States, the Securities and Exchange Commission (SEC) restricts investing in some alternative investments to accredited individuals. An individual qualifies as an accredited investor if they have earned income of USD200,000 or more in each of the prior two years and has a reasonable expectation to earn at least USD200,000 in the current year, or has (alone or together with a spouse) a net worth (excluding his or her primary residence) greater than USD1 million.
This restriction is based on the assumption that wealthier investors are anticipated to have a higher level of investing expertise — or access to professional investment counsel — and possess a greater ability to forgo investment liquidity.
Additional variables of the personal situations of individual investors, such as age and family obligations, may also differ and affect their investing demands and decision making. The planned holding term (time or investment horizon) for investments, risk tolerance, and other conditions also affect investors’ needs.
Retail Investors
The investing sector delivers primarily standardised services to retail investors because they make the least money per investor for investment firms. Many retail investing services are supplied online or by customer service personnel working at call centres.
High-Net-Worth Investors
Wealthier investors often receive more personal attention from financial experts. Their investment problems sometimes involve tax and estate planning complications that demand greater resources and professional knowledge. They either pay directly for these services on a fee-for-service basis or indirectly through commissions and other transaction charges.
Ultra-High-Net-Worth Investors and Family Offices
Very affluent individuals generally employ professionals who help them manage their money, future estates, and legal concerns. These specialists generally operate in a family office, which is a private corporation that administers the financial affairs of one or more members of a family or of numerous families.
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Many family offices serve the heirs of huge family fortunes that have been acquired over generations. In addition to investing services, family offices may provide personal services to the family members, such as bookkeeping, tax planning, managing household personnel, making travel arrangements, and coordinating social events.
Wealthy families generally have huge real estate holdings and large financial portfolios. The investment professionals who work in family offices often handle these investments using the same strategies and processes that institutional investors use. They pay especially close attention to personal and estate tax issues that may considerably affect the family’s wealth and their capacity to transfer money on to future generations or charity institutions.
Institutional Investors
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others. There are numerous different sorts of institutional investors with differing investment criteria and limits. Institutional investors may invest to promote their mission, or they may invest for others to address the others’ needs. Institutional investors that invest to achieve their missions include the following:
Pension plans
Endowment funds and foundations
Trusts
Governments and sovereign wealth funds
Non-financial companies
Institutional investors that invest to provide financial services to their clients include investment companies, banks, and insurance companies. Some institutional investors handle their investments internally and employ investment specialists whose duty is to select the investments.
Other institutional investors outsource the investing of the portfolio to one or more external investment firms. The choice between internal and external management will frequently be influenced by the size of the institutional investor, with larger institutional investors better able to afford the resources required for internal management.
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Some institutional investors will choose a mixed model, managing some assets domestically in which they have competence and outsourcing more specialist investments — for example, alternative investments — to external managers. Those institutional investors that choose to outsource investment management still have significant decisions to make in terms of which managers to choose. They may use internal expertise to make manager selection decisions, or they may employ a consultant.
Pension Plans
Pension plans hold investment portfolios — that is, pension funds — for the benefit of future and existing retired members, who are called beneficiaries.
A firm or other body may set up a pension plan to provide benefits to its employees. The companies and governments that sponsor these plans are termed pension sponsors or plan sponsors. Money from employer and/or employee contributions is placed away to give income to plan members when they retire. The payments must be invested until the employee retires and receives the retirement benefits.
Pension plans differ by whether they are arranged as defined benefit or defined contribution schemes.
Defined Benefit Pension Plans
Defined benefit pension schemes promise a defined annual sum to their retired participants. The set amount normally fluctuates by member based on such factors as years of service and annual income while working.
Typically, employees do not have the right to collect benefits until they have worked for the company or government for a term set by the pension plan. An employee’s rights are vested (covered by law or contract) once they have worked for that duration.
Defined benefit pension funds, particularly those of government-sponsored schemes, are among the largest institutional investors. Pension funds may invest in equities securities, debt securities, and alternative assets because they often have relatively lengthy time horizons.
As employees retire, new employees are added to the plan. If new employees are not being added to the plan, the temporal horizon of the plan will diminish over time.
In a defined benefit pension plan, the sponsoring employer promises its members (or employees) a defined amount of benefit. For example, it is extremely typical for the company to promise a yearly pension that is a specified proportion of the employee’s final pre-retirement income.
The pension may be adjusted for inflation over time. The employer will pay contributions to the pension fund to honor the promise. Employees may also be asked to donate.
In a defined benefit plan, the employer bears the risk – in this example, that the investments made by the pension fund fail to perform as predicted. If the investments fail to perform as planned, the employer may be obliged to make further contributions to the fund.
But it is likely that pension sponsors will be unable to make the necessary contributions and that beneficiaries would not receive the benefits expected. Defined benefit plans are becoming less widespread around the globe and are being replaced by defined contribution plans.
Euro Pension Fund is the fund for a defined benefit pension plan located in Frankfurt, Germany. The plan sponsor remits money to the fund based on projections of pension benefit commitments compared with pension plan assets. Working members of the plan also pay a portion of their wages to the fund.
It has an asset management team that devises the fund’s strategy and implements it.
Defined Contribution Pension Plans
In a defined contribution pension plan, the pension sponsor normally contributes an agreed-on amount — the defined contribution — to an account set up for each employee.
Employees also often contribute to their own retirement plan accounts, primarily through employee payroll deductions.
The contributions are subsequently invested, generally in funds that the employee chooses from a list of approved funds inside the plan.
The plan gives enough options of funds to allow employees to establish a broadly diversified portfolio. The sponsor often limits the selections to a group of mutual funds sponsored by recognized investment managers. The pension plan sponsor should also guarantee that the costs levied on the funds are appropriate. At retirement, the money that has accumulated in the account is available to the employee.
In defined contribution plans, the member (or employee) takes the risk that the pension account’s investments fail to perform as predicted. This contrasts with defined benefit plans, in which the employer takes the risk.
In defined contribution plans, the employer has no commitment to make further payments if the investments perform poorly. If the retirement fund is less than projected, the employee may have to make do with less retirement income or, maybe, defer retirement.
Because saving enough and choosing the correct investments are very important, defined contribution plan sponsors are increasingly providing financial assistance to their beneficiaries or arranging for financial consultants to help guide members.
In the past, most pension plans were defined benefit pension plans. Because these plans promise defined benefits to their beneficiaries, they are expensive responsibilities for the sponsor (company) and many sponsors no longer offer them. This development explains why defined contribution pension plans are progressively replacing defined benefit plans in most countries.
Endowment Funds and Foundations
Endowment funds and foundations are also big institutional investors in many nations. Endowment funds are long-term funds of nonprofit institutions, such as universities, hospitals, and museums.
These institutions use their endowment monies to provide some services to their students, patients, and supporters. Foundations are grant-making institutions funded by gifts and by the investment income that they earn. Most foundations do not directly provide services. Instead, they fund entities that provide services in such areas as the arts or charities. Foundations often own endowment funds, which invest the foundation’s money.
Endowment funds and foundations often have a charity or philanthropic aim and accept endowments from contributors interested in supporting their activities. In many countries, gifts to these institutions are tax deductible for the donors.
That is, gifts diminish the income on which the donors have to pay taxes. Investment income and capital gains that these organisations get from investing these funds may also be tax-exempt.
Endowment funds are normally meant to remain in perpetuity and, as such, are viewed as very long-term investors. But they are also often mandated to spend annually on the benevolent or philanthropic objective for their existence, therefore money needs to be pulled from their funds.
Many endowment funds and foundations adopt spending criteria; for example, they may set expenditure goals of a percentage range of their assets. Often, their issue resides in combining long-term growth with shorter-term income or cash flow requirements.
Each endowment fund or foundation has its own special circumstances. Some are able to raise money on an ongoing basis, but others are limited from raising more money. Some endowment funds and foundations are mandated to spend a fixed part of the portfolio each year, whilst others have more flexibility to adjust spending.
These discrepancies have significance for how the institutional investor’s assets are invested. An endowment client that is barred from fundraising has to meet its financial needs from income or the sale of assets, whereas an endowment client that has no restriction on fundraising may also raise money to satisfy its financial needs.
Most institutions with endowment funds use professional investment managers to manage the funds. Some manage portions of their money domestically, in some cases through an investment management company that they control.
Governments and Sovereign Wealth Funds
Governments receive money from collecting taxes or selling bonds. When they do not have to spend this money immediately, they frequently invest it.
Some governments have accumulated significant surpluses from selling natural resources that they control or from financing the trade of goods and services. They create sovereign wealth funds to invest these surpluses for the benefit of present and future generations of their citizens.
Sovereign wealth funds often invest in long-term securities and assets. They also may purchase companies. Sovereign wealth funds either manage their investments in-house or engage investment managers to manage their money.
Non-Financial Companies
Analysts typically identify companies as either financial companies or non-financial companies.
Financial Companies
Financial companies include investment companies, banks and other lenders, and insurance organizations. These companies provide financial services to its clientele.
Non-Financial Companies
Non-financial enterprises produce items and non-financial services for their consumers.
These companies invest money that they do not presently require to run their businesses.
The money invested by non-financial companies may be invested short-term, mid-term, or long-term. The corporate treasurer usually controls the short-term investment assets. These assets often comprise cash that the company will need shortly to pay salaries and accounts payable and financial vehicles that are safe and liquid, like demand deposits (checking accounts), money market funds, and short-term debt securities issued by governments or other companies.
Long-term investments are normally managed under the leadership of the chief financial officer or the chief investment officer, if the company has one. firms often invest long term to finance future research, investments, and acquisitions of firms and goods. Companies may invest long term directly, or they may hire investment managers to invest on their behalf.
Some corporations invest directly in the shares and bonds of their suppliers and in the shares of possible merger partners to strengthen their relationships with them. Practitioners term these investments ‘strategic investments’. These types of investments are widespread in Asian countries, such as Japan and South Korea, and in European countries, such as France, Germany, and Italy.
Investment Companies
Investment businesses include mutual funds, hedge funds, and private equity funds. These firms operate exclusively to hold investments on behalf of its owners, partners, or unitholders (units refer to shares and bonds for equity and debt securities, respectively). These companies are called pooled investment vehicles because investors in these organizations pool their money for common management.
Investment companies are handled by experienced investment managers that work for investment management organizations. These management businesses often structure and market the investment companies that they manage and so function as the investment sponsors.
Mutual funds pool the assets of many investors into a single investment vehicle, which is professionally managed and benefits from economies of scale. There are thousands of mutual funds administered by investment management businesses.
Mutual funds are often classed by their investment(s). Investments eligible for inclusion may be strictly or broadly defined and based on categories of assets, geographic area, and so on.
For example, mutual funds may specify that they invest in Chinese equities identified as having growth potential, global equities, long-term investment-grade European corporate bonds, or commodities. The investment management business receives a fee for managing the fund. Although a mutual fund can be viewed as an institutional investor, the phrase ‘mutual fund’ also refers to the investment vehicle, shares of which an individual or institutional investor might hold in a portfolio.
Hedge funds and private equity funds can similarly be considered institutional investors that manage private investment pools and as investment vehicles. They are distinguished by their use of tactics outside the limits of most standard mutual funds (discussed in Course 2, Types and Functioning of Markets).
Insurance Companies
Insurance companies form another key group of institutional investor.
Insurance Companies collect premium from persons and companies they cover. Premium are required by insurance firms to offer insurance coverage for the policyholders.
Some of the premiums are deposited into a reserve fund form which insurance coverage can be paid. The premiums in the reverse funds are invested in broad portfolios of securities and assets that attempt to ensure that adequate money are always available to meet all claims.
Regulations typically impose rules to restrict the types of investments insurance firms can keep.
Insurance firms profit from the income they gain form float which is the amount money they have available to use after receiving premium and before paying claims.
There are two primary sorts of insurance businesses.
PROPERTY AND CASUALTY
Property and casualty insurance firms safeguard their insured from the financial loss caused by such catastrophes as accidents and theft.
Property and casualty insurers have short-term views and generally unpredictable payouts; therefore, they favor shorter-term assets that are more cautious and liquid.
LIFE
Life insurance firms give payments to the policyholder’s beneficiaries in the event the policyholder dies while the insurance coverage is in force.
Life insurers have longer-term time horizons and more predictable payouts and, thus, have more leeway to engage in riskier assets. They frequently invest their reserve funds, which often are extremely big, in stocks, commodities, real estate, and other real assets.
Some insurance firms give both forms of insurance.
nsurance businesses aim to match their investments to their responsibilities. For example, if they intend to make fixed annuity payments in the far future, they may invest in long-term fixed-income securities to match the interest rate risk of their assets to the interest rate risk of their liabilities.
This approach of matching investment assets to liabilities, called asset/liability matching, decreases the risk that the company would fail to fulfill its claims.
Most large insurance companies manage their investments in-house. They also may contract with investment managers to oversee specialty investments in industries, asset classes, or geographical regions where they lack expertise or access.
Investors — both individual and institutional — differ in their financial resources, circumstances, objectives, views, financial skills, and so on. These distinctions determine what services the client requires and what types of investments are appropriate for the client. Therefore, it is crucial to record information about the client and the client’s needs.
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Investment- Alpha
Skill vs. Luck
If each person in a roomful of people randomly buys 10 stocks and holds them for five years, some of those persons may see the value of their investments rise. Does this suggest that they are skilful investors? At the same time, other people in the room may watch the value of their investments plummet. Does that suggest that they are terrible investors?
The answer to both queries is no. The stocks were chosen randomly, thus the result is entirely attributable to luck. But even when stocks are not chosen randomly, luck can play a large factor in investment outcomes, so investors need a mechanism to discern between skill and luck.
The calculation and analysis of reward-to-risk ratios allow investors to understand the level of risk that has historically been taken to earn the total return generated by the fund. All things being equal, a manager who delivers a consistently high reward-to-risk ratio could be said to be more competent than one who consistently produces a lower ratio. Investors who invest in a fund that is managed on an active rather than a passive basis are effectively paying for the manager’s investment ability and expertise.
Manager skill is commonly referred to as alpha. Perhaps the best approach to describe the concept of alpha is to evaluate the sources of a fund’s return, which is formed of three elements:
Market return
Luck Skill
Market Return Managers of passive funds attempt to provide returns for investors just as active managers intend to produce returns. But passive managers are not attempting to generate value by picking stocks that they feel will outperform other securities. Instead, they typically acquire and hold in the appropriate amounts only those securities that are contained in their benchmark. Although this procedure involves some expertise, it is not so much investment skill as effective management. When the value of the benchmark rises, the value of the passive fund monitoring it should also rise; conversely, when the value of the benchmark declines, the value of the passive fund should also fall. Therefore, over time, the fund should deliver a return (before the deduction of costs) equivalent to that of the set benchmark
Given that most actively managed funds are benchmarked against market indexes, such as the S&P 500, and fund managers will own many of the same securities that are in the index, some of the return generated by an actively managed fund will come from market movements due to the benchmark. Arguably then, investors in actively managed funds should not pay higher fees for fund returns that are generated by the market rather than by the investment acumen of their fund manager because investors can get market returns more cheaply by participating in passively managed funds.
Luck
Some of the return earned by a fund is the consequence of luck rather than discretion. The prices of financial assets held in funds are altered by events that cannot be expected by a fund management, such as natural disasters or geopolitical events.
Skilful fund managers may be unlucky on sometimes while unskilled fund managers could experience some good luck. Because luck tends to equal out over the long term, it is crucial that investors are able to separate luck from expertise. But it is not always easy to do so.
Skill A skillful fund manager is able to contribute value to a fund over and above changes to the fund’s value that are driven by market movements and that might have been achieved by a passive fund manager.
Because luck may even out over time, a skilful manager is one who contributes this value consistently over time. Outperformance over the returns from a relevant market benchmark that are the result of manager talent and not luck is often referred to as alpha.
Distinguishing Between Sources of Return
Investors strive to discern between these three sources of fund returns. To do so, reward-to-risk ratios, such as the Sharpe ratio and the information ratio, are evaluated together with other indicators, such as a fund’s alpha, beta, standard deviation, and tracking error. A careful review of these variables over multiple time periods can assist investors decide whether outperformance has lasted over time and whether there is evidence of manager talent.
Skill vs. Luck
If each person in a roomful of people randomly buys 10 stocks and holds them for five years, some of those persons may see the value of their investments rise. Does this suggest that they are skilful investors? At the same time, other people in the room may watch the value of their investments plummet. Does that suggest that they are terrible investors?
The answer to both queries is no. The stocks were chosen randomly, thus the result is entirely attributable to luck. But even when stocks are not chosen randomly, luck can play a large factor in investment outcomes, so investors need a mechanism to discern between skill and luck.
The calculation and analysis of reward-to-risk ratios allow investors to understand the level of risk that has historically been taken to earn the total return generated by the fund. All things being equal, a manager who delivers a consistently high reward-to-risk ratio could be said to be more competent than one who consistently produces a lower ratio. Investors who invest in a fund that is managed on an active rather than a passive basis are effectively paying for the manager’s investment ability and expertise.
Manager skill is commonly referred to as alpha. Perhaps the best approach to describe the concept of alpha is to evaluate the sources of a fund’s return, which is formed of three elements:
Market return
Luck Skill
Market Return Managers of passive funds attempt to provide returns for investors just as active managers intend to produce returns. But passive managers are not attempting to generate value by picking stocks that they feel will outperform other securities. Instead, they typically acquire and hold in the appropriate amounts only those securities that are contained in their benchmark. Although this procedure involves some expertise, it is not so much investment skill as effective management. When the value of the benchmark rises, the value of the passive fund monitoring it should also rise; conversely, when the value of the benchmark declines, the value of the passive fund should also fall. Therefore, over time, the fund should deliver a return (before the deduction of costs) equivalent to that of the set benchmark
Given that most actively managed funds are benchmarked against market indexes, such as the S&P 500, and fund managers will own many of the same securities that are in the index, some of the return generated by an actively managed fund will come from market movements due to the benchmark. Arguably then, investors in actively managed funds should not pay higher fees for fund returns that are generated by the market rather than by the investment acumen of their fund manager because investors can get market returns more cheaply by participating in passively managed funds.
Luck
Some of the return earned by a fund is the consequence of luck rather than discretion. The prices of financial assets held in funds are altered by events that cannot be expected by a fund management, such as natural disasters or geopolitical events.
Skilful fund managers may be unlucky on sometimes while unskilled fund managers could experience some good luck. Because luck tends to equal out over the long term, it is crucial that investors are able to separate luck from expertise. But it is not always easy to do so.
Skill A skillful fund manager is able to contribute value to a fund over and above changes to the fund’s value that are driven by market movements and that might have been achieved by a passive fund manager.
Because luck may even out over time, a skilful manager is one who contributes this value consistently over time. Outperformance over the returns from a relevant market benchmark that are the result of manager talent and not luck is often referred to as alpha.
Distinguishing Between Sources of Return
Investors strive to discern between these three sources of fund returns. To do so, reward-to-risk ratios, such as the Sharpe ratio and the information ratio, are evaluated together with other indicators, such as a fund’s alpha, beta, standard deviation, and tracking error. A careful review of these variables over multiple time periods can assist investors decide whether outperformance has lasted over time and whether there is evidence of manager talent.
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Investment- Performance Attribution
Benchmarks constitute the basis of performance measurement, which is an important aspect of performance evaluation. By comparing the performance of a UK equity fund with the performance of an appropriate UK equity index, the fund’s investors can get an idea of how well the fund is performing relative to the market in general, both in terms of average return and in terms of risk, by calculating the fund’s tracking error or information ratio.
Benchmarks can also be utilized to analyze the causes behind the fund’s performance. By employing proper financial market indicators, the fund manager’s performance can be deconstructed to uncover the sources of returns. Depending on the nature of the fund, the performance itself could originate from the following sources:
Asset allocation
Sector selection
Stock selection
Currency exposure
Determining how much of the performance is the consequence of the choices of asset classes, sectors, individual stocks, and currencies is known as performance attribution. The following example provides an illustration of performance attribution.
Benchmarks constitute the basis of performance measurement, which is an important aspect of performance evaluation. By comparing the performance of a UK equity fund with the performance of an appropriate UK equity index, the fund’s investors can get an idea of how well the fund is performing relative to the market in general, both in terms of average return and in terms of risk, by calculating the fund’s tracking error or information ratio.
Benchmarks can also be utilized to analyze the causes behind the fund’s performance. By employing proper financial market indicators, the fund manager’s performance can be deconstructed to uncover the sources of returns. Depending on the nature of the fund, the performance itself could originate from the following sources:
Asset allocation
Sector selection
Stock selection
Currency exposure
Determining how much of the performance is the consequence of the choices of asset classes, sectors, individual stocks, and currencies is known as performance attribution. The following example provides an illustration of performance attribution.
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Investment- Risk-Adjusted Returns
Most investors aim to gain as much profit as possible for as little risk as feasible. Therefore, if two investments have a total return of 10% and the first investment has very little risk while the second one is quite dangerous, the first investment is better than the second one on a risk-adjusted basis.
Standard Deviation
Risk can take numerous forms. The risk we refer to throughout the rest of this module is investment risk. In Course 3, Investment Instruments, you learned that investment risk is commonly quantified based on the unpredictability of returns, and a common measure of variability is the standard deviation. The standard deviation of returns represents the variability of returns around the mean (or average) return — the larger the standard deviation of returns, the higher the variability of returns and the higher the risk.
There are at least two reasons why investors care about historical variability (the standard deviation of past returns). First, prior variability of returns might be indicative of how variable returns may be in the future. But it is vital to be aware that variability can alter over time and that there is no guarantee that future returns will behave like past returns.
Second, the variability of returns may impair the attainment of an investor’s objectives. Pension funds invest to create the returns necessary to pay their beneficiaries, insurance companies invest to generate returns to meet the claims on their policies, and people invest because they usually have a future spend in mind. Investing in a fund whose returns vary dramatically over time could possibly disturb investors’ plans. If returns are substantially negative one year, then the investors’ commitments, such as paying pensions, may be harder to meet.
Downside Deviation
Standard deviation is a measure of the variability of returns around the mean. Sometimes there is a positive deviation — that is, the return is more than the mean — and sometimes there is a negative deviation — that is, the return is less than the mean. Which of these two sorts of variation do you think investors would be more concerned about?
Well, psychologists and economists have discovered that investors loathe losses more than they prefer similar gains. So, investors can be moderately happy with earning an investment return of +10%, but quite upset about achieving a return of –10%. Because of this asymmetry in the way investors see the dispersion around the average, some investing professionals utilize a modified version of standard deviation known as downside deviation.
Downside deviation is computed in almost precisely the same way as standard deviation, except instead of utilizing all the deviations from the mean — positive and negative — downside deviation is calculated using only negative deviations. In other words, it is a measure of return variability that emphasizes primarily on outcomes that are less than the mean. Downside deviation may also be evaluated by focused on outcomes that are below a defined return target.
The following illustration demonstrates the standard and downside deviations of returns associated with investing in a diversified fund of global stocks and in a diversified fund of global bonds.
As we see, the downside deviations are lower than the standard deviations; this outcome is expected because downside deviations only consider the negative variances. Investors who are confined in their willingness or ability to endure losses will likely prefer the bond fund given its 3.8% downside deviation and reduced chance of losses against the equity fund with its 10.4% downside deviation and larger predicted losses.
Reward-to-Risk Ratios
Investors seek to earn a large return rather than a low return on their assets. That said, all things being equal, they also prefer lower risk (less variability of returns) over higher risk (more variability of returns).
In other words, investors are interested in optimizing the return on their investments while simultaneously striving to limit the dangers. That is, they choose investments that offer a high return per unit of risk — assets with a high reward-to-risk ratio. The measurement of a reward-to-risk ratio allows investors to compare the performance of one investment with another on a risk-adjusted basis.
A reward-to-risk ratio is a measure that takes the following basic form:
Most investors aim to gain as much profit as possible for as little risk as feasible. Therefore, if two investments have a total return of 10% and the first investment has very little risk while the second one is quite dangerous, the first investment is better than the second one on a risk-adjusted basis.
Standard Deviation
Risk can take numerous forms. The risk we refer to throughout the rest of this module is investment risk. In Course 3, Investment Instruments, you learned that investment risk is commonly quantified based on the unpredictability of returns, and a common measure of variability is the standard deviation. The standard deviation of returns represents the variability of returns around the mean (or average) return — the larger the standard deviation of returns, the higher the variability of returns and the higher the risk.
There are at least two reasons why investors care about historical variability (the standard deviation of past returns). First, prior variability of returns might be indicative of how variable returns may be in the future. But it is vital to be aware that variability can alter over time and that there is no guarantee that future returns will behave like past returns.
Second, the variability of returns may impair the attainment of an investor’s objectives. Pension funds invest to create the returns necessary to pay their beneficiaries, insurance companies invest to generate returns to meet the claims on their policies, and people invest because they usually have a future spend in mind. Investing in a fund whose returns vary dramatically over time could possibly disturb investors’ plans. If returns are substantially negative one year, then the investors’ commitments, such as paying pensions, may be harder to meet.
Downside Deviation
Standard deviation is a measure of the variability of returns around the mean. Sometimes there is a positive deviation — that is, the return is more than the mean — and sometimes there is a negative deviation — that is, the return is less than the mean. Which of these two sorts of variation do you think investors would be more concerned about?
Well, psychologists and economists have discovered that investors loathe losses more than they prefer similar gains. So, investors can be moderately happy with earning an investment return of +10%, but quite upset about achieving a return of –10%. Because of this asymmetry in the way investors see the dispersion around the average, some investing professionals utilize a modified version of standard deviation known as downside deviation.
Downside deviation is computed in almost precisely the same way as standard deviation, except instead of utilizing all the deviations from the mean — positive and negative — downside deviation is calculated using only negative deviations. In other words, it is a measure of return variability that emphasizes primarily on outcomes that are less than the mean. Downside deviation may also be evaluated by focused on outcomes that are below a defined return target.
The following illustration demonstrates the standard and downside deviations of returns associated with investing in a diversified fund of global stocks and in a diversified fund of global bonds.
As we see, the downside deviations are lower than the standard deviations; this outcome is expected because downside deviations only consider the negative variances. Investors who are confined in their willingness or ability to endure losses will likely prefer the bond fund given its 3.8% downside deviation and reduced chance of losses against the equity fund with its 10.4% downside deviation and larger predicted losses.
Reward-to-Risk Ratios
Investors seek to earn a large return rather than a low return on their assets. That said, all things being equal, they also prefer lower risk (less variability of returns) over higher risk (more variability of returns).
In other words, investors are interested in optimizing the return on their investments while simultaneously striving to limit the dangers. That is, they choose investments that offer a high return per unit of risk — assets with a high reward-to-risk ratio. The measurement of a reward-to-risk ratio allows investors to compare the performance of one investment with another on a risk-adjusted basis.
A reward-to-risk ratio is a measure that takes the following basic form:
The higher the value of the reward-to-risk ratio, the better the risk-adjusted return – that is, the higher the return per unit of risk.
A commonly used reward-to-risk ratio is the Sharpe ratio, so-called because it was initially suggested by Nobel Prize–winning economist William Sharpe.1 A fund’s reward is measured as the fund’s excess return, which is equal to the difference between the fund’s total return and the return on a ‘risk-free’ investment. The risk-free investment return is usually the return from investing in short-term government bonds because in most nations, government bonds are the assets that entail the lowest level of risk. The measure of fund risk is the standard deviation of the fund returns. The Sharpe ratio is determined as follows:
A commonly used reward-to-risk ratio is the Sharpe ratio, so-called because it was initially suggested by Nobel Prize–winning economist William Sharpe.1 A fund’s reward is measured as the fund’s excess return, which is equal to the difference between the fund’s total return and the return on a ‘risk-free’ investment. The risk-free investment return is usually the return from investing in short-term government bonds because in most nations, government bonds are the assets that entail the lowest level of risk. The measure of fund risk is the standard deviation of the fund returns. The Sharpe ratio is determined as follows:
Another often used reward-to-risk ratio is the Treynor ratio, introduced by Jack Treynor.2 The measure of fund reward is the same as that used in the Sharpe ratio, but the measure of fund risk is different. The measure of fund risk is the beta of the fund — beta being a measure of the fund’s systematic risk (also called market risk). Systematic risk was explored in the Investment Management module of this course. Thus, the Treynor ratio is a measure of the fund’s performance in relation to the degree of market risk assumed by the manager. The Treynor ratio is determined as follows:
Example: Calculation of Sharpe and Treynor Ratios
Suppose that over a year, the overall return of a fund was 10% and the return from investing in government bonds (‘risk-free’ assets) was 4%. Also assume that the standard deviation and beta of the fund’s returns over this period were 5% and 1.8, respectively.
The Sharpe ratio for this fund is
Suppose that over a year, the overall return of a fund was 10% and the return from investing in government bonds (‘risk-free’ assets) was 4%. Also assume that the standard deviation and beta of the fund’s returns over this period were 5% and 1.8, respectively.
The Sharpe ratio for this fund is
The Treynor ratio for this fund is
Each of these ratios can be compared with the same ratios for similar funds to evaluate the fund’s performance. As stated previously, the higher the value of the reward-to-risk ratio, the better the risk-adjusted return — that is, the higher the return per unit of risk.
The Sharpe ratio — along with other reward-to-risk ratios, such as the information ratio — is a key indicator for determining the quality of the returns provided by a fund. A fund with high returns but with significant risk might be said to have delivered worse-quality returns than a fund with similarly high returns but with substantially reduced risk. Reward-to-risk ratios, such as the Sharpe ratio, are one of the key quality control checks that investors can apply to their investment returns. Such ratios are also beneficial for comparing and analyzing investments.
The Sharpe ratio — along with other reward-to-risk ratios, such as the information ratio — is a key indicator for determining the quality of the returns provided by a fund. A fund with high returns but with significant risk might be said to have delivered worse-quality returns than a fund with similarly high returns but with substantially reduced risk. Reward-to-risk ratios, such as the Sharpe ratio, are one of the key quality control checks that investors can apply to their investment returns. Such ratios are also beneficial for comparing and analyzing investments.
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Investment -Benchmarks and Relative Returns
Benchmarks and Relative Returns
By measuring relative returns — that is, returns compared to an appropriate benchmark — investors can decide if they could have made more money in other investments for a similar degree of risk. Assessing returns on a relative basis allows investors to analyze their opportunity cost and determine whether their investments are delivering suitable returns.
Many investors wish to compare the performance of their fund with that of a financial market benchmark, such as a stock index. It is widespread practice in all businesses, and indeed in many spheres of life, to benchmark or compare performance. Olympic sprinters, for instance, may compare themselves to a time benchmark or a close competition. Beating the time standard or the rival allows them to determine how they are performing.
" " Fund managers may use a benchmark not only for assessment, but some, such as index fund managers, may also manage their funds to a benchmark. This means that managers must periodically compare the composition and performance of their funds with the composition of a financial market index, such as the FTSE 100 Index or the S&P 500 Index. For investors, understanding the financial market index that a fund uses as a benchmark can offer them some sense of the return and risk that they can expect from investing in that fund.
When choosing a manager for a separately managed account mandate, institutional investors will often define the financial market benchmark that they intend to use to judge the performance of the investment manager. For example, a US stock manager may be asked, or ordered, to actively manage a portfolio of US equities for a client and instructed that they will be ‘benchmarked against’ the S&P 500. As another example, a manager may simply be a passive index fund manager tracking the S&P 500 as the reference index. Alternatively, a manager can be given a specific mandate reflecting style or sector preferences. In this situation, a style or sector index may be chosen as the suitable benchmark.
To assist investors reach their objectives, a benchmark should meet specific requirements.
Investable
The benchmark should be constituted of assets that can be bought and sold by the fund manager. For passive fund managers, it would be impossible to match the benchmark if it featured assets that they could not buy. For active fund managers, not being able to invest in some of the benchmark’s components could limit their potential to outperform it.
Compatible
The benchmark should have an appropriate composition and level of risk for the investor. In other words, it should meet the investor’s objectives. For example, for investors who desire to invest in assets that carry little credit or default risk, a financial market index of government bonds might be compatible (based on previous performance) with investor preferences. A benchmark composed of corporate bonds would not be compatible.
Transparent
The guidelines regulating the construction of the benchmark should be explicit. This transparency should extend to the weighting of individual benchmark constituents, to the mechanism used to generate benchmark returns, and to the process used to add and remove constituents to and from the benchmark over time.
Pre-Specified
The benchmark should be defined before an investment is made so that the fund management is aware about the fund’s objectives and so the fund manager may create a portfolio accordingly.
Indices
Several companies publish financial market indexes that allow investors to compare the total return earned by a fund with that generated by the wider market.
For most equities exchanges across the world, there is at least one index that represents the bulk of its stocks. In addition to these broad indices, stock indices that evaluate performance of industrial sectors are also available, both within a given country and globally. These indices make it possible, for instance, for investors to compare the performance of a fund of global information technology (IT) equities with the performance of a fund of Indian IT stocks, as long as the indexes have been built using the same technique.
Index providers also supply a wide selection of bond indexes. Bond indices are offered for several types of issuers located in various locations, including in developed and emerging countries. In addition to aggregate bond indices that are designed to cover the bond market as a whole, bond indices exist for bonds classified by maturity, credit rating, currency, and industry, among other categories. Many index providers, such as FTSE International, S&P Dow Jones, and MSCI, produce indexes for practically every asset class, including cash, currencies, commercial property, hedge funds, private equity, and commodities, as well as for bonds and equities.
Relative Returns
The large selection of financial market indices available enables investors to compare the performance of their fund over time against an independent benchmark. In brief, a benchmark index allows investors to evaluate relative returns.
Some investors compare their fund’s performance with that of the fund’s peers. For example, investors may compare the performance of one European equities fund with that of other European equity funds.
Each fund is granted a performance ranking within its particular sector of the financial markets. Funds that are in the top 10% of performers among their peers during a certain period are said to be top-decile performers. Funds’ performance is often collected and assessed by independent organisations, such as Morningstar, who then publishes the data, allowing investors to examine the rankings of their particular funds relative to those of other funds that they may have chosen.
Benchmarks and Relative Returns
By measuring relative returns — that is, returns compared to an appropriate benchmark — investors can decide if they could have made more money in other investments for a similar degree of risk. Assessing returns on a relative basis allows investors to analyze their opportunity cost and determine whether their investments are delivering suitable returns.
Many investors wish to compare the performance of their fund with that of a financial market benchmark, such as a stock index. It is widespread practice in all businesses, and indeed in many spheres of life, to benchmark or compare performance. Olympic sprinters, for instance, may compare themselves to a time benchmark or a close competition. Beating the time standard or the rival allows them to determine how they are performing.
" " Fund managers may use a benchmark not only for assessment, but some, such as index fund managers, may also manage their funds to a benchmark. This means that managers must periodically compare the composition and performance of their funds with the composition of a financial market index, such as the FTSE 100 Index or the S&P 500 Index. For investors, understanding the financial market index that a fund uses as a benchmark can offer them some sense of the return and risk that they can expect from investing in that fund.
When choosing a manager for a separately managed account mandate, institutional investors will often define the financial market benchmark that they intend to use to judge the performance of the investment manager. For example, a US stock manager may be asked, or ordered, to actively manage a portfolio of US equities for a client and instructed that they will be ‘benchmarked against’ the S&P 500. As another example, a manager may simply be a passive index fund manager tracking the S&P 500 as the reference index. Alternatively, a manager can be given a specific mandate reflecting style or sector preferences. In this situation, a style or sector index may be chosen as the suitable benchmark.
To assist investors reach their objectives, a benchmark should meet specific requirements.
Investable
The benchmark should be constituted of assets that can be bought and sold by the fund manager. For passive fund managers, it would be impossible to match the benchmark if it featured assets that they could not buy. For active fund managers, not being able to invest in some of the benchmark’s components could limit their potential to outperform it.
Compatible
The benchmark should have an appropriate composition and level of risk for the investor. In other words, it should meet the investor’s objectives. For example, for investors who desire to invest in assets that carry little credit or default risk, a financial market index of government bonds might be compatible (based on previous performance) with investor preferences. A benchmark composed of corporate bonds would not be compatible.
Transparent
The guidelines regulating the construction of the benchmark should be explicit. This transparency should extend to the weighting of individual benchmark constituents, to the mechanism used to generate benchmark returns, and to the process used to add and remove constituents to and from the benchmark over time.
Pre-Specified
The benchmark should be defined before an investment is made so that the fund management is aware about the fund’s objectives and so the fund manager may create a portfolio accordingly.
Indices
Several companies publish financial market indexes that allow investors to compare the total return earned by a fund with that generated by the wider market.
For most equities exchanges across the world, there is at least one index that represents the bulk of its stocks. In addition to these broad indices, stock indices that evaluate performance of industrial sectors are also available, both within a given country and globally. These indices make it possible, for instance, for investors to compare the performance of a fund of global information technology (IT) equities with the performance of a fund of Indian IT stocks, as long as the indexes have been built using the same technique.
Index providers also supply a wide selection of bond indexes. Bond indices are offered for several types of issuers located in various locations, including in developed and emerging countries. In addition to aggregate bond indices that are designed to cover the bond market as a whole, bond indices exist for bonds classified by maturity, credit rating, currency, and industry, among other categories. Many index providers, such as FTSE International, S&P Dow Jones, and MSCI, produce indexes for practically every asset class, including cash, currencies, commercial property, hedge funds, private equity, and commodities, as well as for bonds and equities.
Relative Returns
The large selection of financial market indices available enables investors to compare the performance of their fund over time against an independent benchmark. In brief, a benchmark index allows investors to evaluate relative returns.
Some investors compare their fund’s performance with that of the fund’s peers. For example, investors may compare the performance of one European equities fund with that of other European equity funds.
Each fund is granted a performance ranking within its particular sector of the financial markets. Funds that are in the top 10% of performers among their peers during a certain period are said to be top-decile performers. Funds’ performance is often collected and assessed by independent organisations, such as Morningstar, who then publishes the data, allowing investors to examine the rankings of their particular funds relative to those of other funds that they may have chosen.
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Investment- Tracking Error and Information Ratio
The tracking error of a fund reveals how the performance of the fund deviates from the performance of its benchmark. The tracking error so informs you how much active risk the manager took.
The tracking error is measured by taking the standard deviation of the discrepancies between the returns on the fund and the returns on its benchmark. The bigger these variances, the more active risk was taken and the worse the tracking inaccuracy. A passive fund may be expected to have a very low tracking error relative to its benchmark index because the management is aiming to duplicate an index. But for an actively managed fund, the tracking error should be larger.
Tracking error can also be utilized to build another widely used reward-to-risk ratio known as the information ratio. The information ratio tells you how much benefit a manager generated given the amount of active risk they took relative to the benchmark. In other words, did a manager’s wagers against the benchmark pay off? The ‘reward’ element of the information ratio is the difference between the total return of the fund and the return of an applicable benchmark index over the same period. The ‘risk’ element of the information ratio is based on the tracking error of the fund — that is, its departure from the performance of the benchmark. It is calculated as follows:
The tracking error of a fund reveals how the performance of the fund deviates from the performance of its benchmark. The tracking error so informs you how much active risk the manager took.
The tracking error is measured by taking the standard deviation of the discrepancies between the returns on the fund and the returns on its benchmark. The bigger these variances, the more active risk was taken and the worse the tracking inaccuracy. A passive fund may be expected to have a very low tracking error relative to its benchmark index because the management is aiming to duplicate an index. But for an actively managed fund, the tracking error should be larger.
Tracking error can also be utilized to build another widely used reward-to-risk ratio known as the information ratio. The information ratio tells you how much benefit a manager generated given the amount of active risk they took relative to the benchmark. In other words, did a manager’s wagers against the benchmark pay off? The ‘reward’ element of the information ratio is the difference between the total return of the fund and the return of an applicable benchmark index over the same period. The ‘risk’ element of the information ratio is based on the tracking error of the fund — that is, its departure from the performance of the benchmark. It is calculated as follows:
