Investment Policy of Institutional Investors

The Investment Policy Statement is the governing document for managers working with institutional investors, just as it is with individual investors. The IPS outlines the goals and objectives of the institution and serves as a guide that predetermines how the portfolio will be managed. Investment objectives flow from the organization's overall mission.

For banks and insurance companies, the investment objective is to maximize net present value by balancing:

• The expected returns on assets.
• The expected cost of liabilities.
• The overall risks of assets and liabilities.
• The economic relationships between and among assets and liabilities.

Investment objectives are typically simpler for other types of institutions, such as endowments or foundations, expressed as a desired return target over the medium-to-long term (which should be clearly specified) with an acceptable level of risk. In the case of a pension plan, these goals could be expressed as a desired funded status, say 100% +.

Investment objectives and return targets must be consistent with an organization's risk tolerance and other constraints. Risk tolerance can be expressed in different ways, such as:

Defined-benefit pension funds: Surplus volatility (standard deviation of asset returns in excess of liability returns);

Sovereign wealth funds: The probability of investment losses (or probability of not maintaining purchasing power) over a certain time period;

Endowments and foundations: Volatility of total returns (standard deviation of total returns); and

Banks and insurance companies: value at risk (VaR) or conditional VaR (CVaR) and comprehensive, scenario-based stress tests.

Once the investment objectives have been established, a strategic asset allocation or policy portfolio is created. The investment portfolio of an institutional investor is designed to meet its objectives and should reflect appropriate risk and liquidity considerations. While institutional investors each have unique liability characteristics, several investment approaches have emerged over the past couple of years. These can be grouped into four different approaches:

$$
\begin{array}{l|l}
\textbf{Investment Approach} & \textbf{Description} \\ \hline
\bf{\textit{Norway model}} & { \text{Features a 60/40 equity/fixed-income} \\ \text{allocation, few alternatives, mostly} \\ \text{passive investments, tight tracking} \\ \text{error limits, and benchmarks as a} \\ \text{starting position.}} \\ \hline
\bf{\textit{Endowment model}} & {\text{This model is defined by high} \\ \text{alternatives exposure, active} \\ \text{management, and outsourcing of asset} \\ \text{management.}} \\ \hline
\bf{\textit{Canada model}} & {\text{Characterized by high alternatives} \\ \text{exposure, active management, and} \\ \text{insourcing of asset management.}} \\ \hline
\bf{\textit{LDI model}} & {\text{Invests in fixed-income securities} \\ \text{with duration-matched exposure to} \\ \text{hedge liabilities and interest rate risk.} \\ \text{A growth component in the} \\ \text{return-generating portfolio is also} \\ \text{frequently used (except for bank and} \\ \text{insurance company portfolios).}}
\end{array} $$

The pros and cons for each model can be summarized as follows:

Norway model: Pros: Low costs, transparency, scalability of strategy, easy for board members to understand. Cons: Limited potential to beat market returns.

Endowment model: Pros: High potential to beat market returns. Cons: Not feasible for most sovereign wealth funds due to their large asset sizes and high costs.

Canada model: Pros: High potential to beat market returns and development of internal capabilities. Cons: Often expensive and difficult to manage.

LDI model: Pros: Carefully satisfies liabilities in a systematic way. Cons: Certain risks may not be hedged.

Question

A model characterized by 60%/40% equity and fixed-income allocation, with few alternatives, and a largely passive investment scheme can best be summarized as:

1. The Endowment Model.
2. The Canada Model.
3. The Norway Model.

Solution

The correct answer is C.

The Norway model limits exposure to alternatives in favor of stocks and bonds. While this works well for large-scale implementation (higher levels of assets under management), it does reduce the potential to beat market returns as it is largely a passive approach.

A and B are incorrect. Both the Canada and the endowment model have a high allocation to alternative assets, which gives them their increased potential for value add.

Portfolio Construction: Learning Module 5: Portfolio Management for Institutional Investors; Los 5(f) Evaluate the investment policy statement of an institutional investor