Chapter 24 PROFESSIONAL AND INSTITUTIONAL ,MONEY MANAGEMENT

Seeking the Help of Experts

Outline
Difference between Individual investors and Institutional Investors. Structures of Professional Money Management General Principles of Asset-Liability Management Institutional Investors Portfolio Management Service Hedge Funds Three Errors of the Investment Management Industry

Differences Between Individual Investors and Institutional Investors

According to Kaiser, the key differences between individual investors and institutional investors are as follows: 1. 2. Individuals define risk as losing money, whereas institutions define risk in terms of standard deviation of return. Individuals can be categorised by their personalities (or psychographics) whereas institutions can be categorised by the investment characteristics of their beneficiaries. Individuals enjoy great freedom to invest the way they want, whereas institutions are subject to various legal constraints. Taxes often matter a great deal for individual investors, whereas many institutions such as mutual funds, pension funds, and insurance companies are tax-exempt entities. Individuals are generally defined financially by their assets and goals (particularly in relation to their stage in their life cycle), whereas Institutions are generally defined by packages of assets and liabilities.

3. 4.

5.

Structures of Professional Money Management

Private Management Firms Investment Companies

Personalised solution
Separate account Fee consists of a fixed component and a variable component

Generic solution
Commingled account Fee is a fixed percentage of the NAV

Risks Associated with Financial Assets

An investor is exposed to one or more of the following risks when investing in financial assets.

Risk Price risk Default risk Inflation risk Exchange rate risk Reinvestment risk

Liquidity risk Call risk

Example The market price of the asset falls The issuer of the asset is unable to meet its obligations Due to inflation, the real value of the asset is eroded Due to a change in exchange rate, the value of a foreign-denominated asset falls The cash flow received from an asset has to be invested in a similar asset that offers a lower return An asset cannot be sold easily at a fair price The issuer of an asset exercises its right to redeem the asset prematurely

Nature of Liabilities

Liability Type Type A Type B

Amount of Timing of Cash Cash Outlay Outlay Known Known Known Uncertain

Example Fixed rate deposit in a bank A whole life assurance policy (non-participating) A two-year floating certificate of deposit An automobile policy rate

Type C

Uncertain

Known

Type D

Uncertain

Uncertain

insurance

Asset-Liability Management
As Alfred Weinberger put it, Asset/liability management is the

prudent

assessment of

trade-offs. The emphasis from the

asset/liability perspective is on risk control, but it is important not to lose sight of the other axis, that of profit or return enhancement.

Types of Surpluses
Three types of surpluses may be calculated by institutions: Economic surplus

Accounting surplus
Regulatory surplus

Economic surplus = Market value of assets Market value of liabilities .

Accounting surplus is calculated on the basis of periodical financial statements

prepared by a financial institution in conformity with the generally accepted accounting principles (GAAP)

Regulatory surplus is the surplus on the basis of financial statements prepared accounting to Regulatory Accounting Principles (RAP), prescribed by the regulator governing a given institution. RAP may not be fully congruous with GAAP

Accounting Treatment of Financial Securities

As far as financial securities are concerned, the accounting treatment depends on how the security is classified. There are three classifications for securities: Held-to-maturity Available for sale Held for trading.

The held-to-maturity account includes assets that the institution plans to hold till maturity. Obviously, equity shares cannot be included in this account, as they have no maturity. For all other assets held in this account, the amortised cost or historical method is used. An asset is classified as an available-for-sale asset account if the institution lacks the ability to hold it till maturity or plans to sell it before maturity. An asset is classified as an heldfor-trading account, if the asset is acquired with a view to earning a short-term trading profit from market movements. For assets held in available for sale account as well as held-for-trading account, market value accounting is used. Institutional investors are typically subject to regulations. For examples, banks are regulated by the Reserve Bank of India and insurance companies are regulated by the Insurance Regulatory and Development and Authority. Institutional investors are required to provide to regulators financial reports prepared according to regulatory accounting principles (RAP). RAP may not be fully congruous with GAAP. The surplus as measured by RAP accounting is referred to as regulatory surplus.

Characteristics of Investment Management

Investment management business has the following characteristics: 1. It is very easy to get into the business of investment management, assuming that the regulatory requirements are met. 2. A market share beyond some level appears to be detrimental to product quality. 3. Diminishing returns from scale seem to set in rather early. 4. Investment management business is highly sensitive to exogenous economic forces. 5. Many talented academics argue that he worth of investment management is zero: They are right in the sense that one-half of the money managed by investment management firms will perform below average.

Institutional Investors
The major institutional investors are Insurance companies Banks Pension funds Endowment funds Investment companies

Life Insurance Companies

Life insurance companies write a variety of policies, the more important ones being the endowment assurance plan, money back plan,

whole life assurance plan, unit linked insurance plan, and term assurance
plan. In addition, life insurance companies sell annuity products.

The liabilities of a life insurance company are defined by the

policies it writes and the annuity products it sells. Obviously, life insurance companies invest so as to hedge their liabilities. Given the nature of their

liabilities, life insurance companies predominantly invest in government

securities. The investment guidelines issued by regulatory authorities also prescribe such a pattern of investment.

Banks
The principal liabilities of banks are in the form of accounts of depositors. The cost of deposits is more for fixed deposits of longer tenors

(say two to five years) and less for CASA (current and savings account)
that is why banks strive to improve their CASA ratio.

Most bank assets are in the form of loans and advances to

businesses and individuals. In addition, banks also invest a fair proportion of their assets (25 to 30 percent or so) in government bonds and other

securities, largely to fulfill certain statutory requirements.

Banks try to

match the risk of assets to liabilities while maintaining a healthy spread between the lending and borrowing rates.

Pension Funds
The two basic types of pension plans are defined contribution plans and defined benefit plans. Defined contribution plans are essentially savings accounts established by the firm for its employees. While the employer contributes funds to the plan, the employee assumes the risk of the funds investment performance. Under these plans, the obligation of the firm is limited to making the stipulated contributions to the retirement account of the employee. The employee has the discretion of choosing among several investment funds (or schemes) in which the assets can be placed. By contrast, in defined benefit plans the firm (employer) is obliged to provide a specified annual retirement benefit to its employees. The benefit is determined by a formula which takes into account the level of salary and the years of service. The payments represent the obligation of the employer, and the assets in the pension fund serve as a collateral for the promised benefits. The risk of the funds investment performance is borne by the employer. Should the investment performance of the fund be poor, the firm has an obligation to make good the shortfall by contributing more to the fund.

Pension Funds
The amount the firm must contribute regularly to the fund to meet its liabilities is computed by a pension actuary on the basis of the rate of return the fund will earn on its assets. If the actual rate of return exceeds the assumed rate, the shareholders of the sponsoring

firm gain because the excess return can be used to lower future
contributions. But if the actual rate of return is less than the assumed rate, the firm will have to increase future contributions.

Since the sponsoring firms shareholders assume the risk of a

defined benefit pension plan, the objective of the plan must be consistent with the objective of the firms shareholders.

Endowment Funds
Endowment funds are held by organisations that are mandated to use their money for specific non-profit purposes. They are financed

by contributions from one or more sponsors, and generally managed

by charitable, educational, and cultural organisations or by independent foundations created solely to carry out the specific purposes of the fund. Typically, the investment objective of an endowment fund is to generate a steady flow of income without

much risk. Hence, the investment portfolio of the firm should

subserve this objective.

Non-Life Insurance Companies

Non-life insurance companies, also called property and casualty insurance companies, (P&C companies) provide a broad range of insurance protection against (i) loss, damage, or destruction of property, (ii) loss or impairment of earning capacity, (iii) claims for damages claimed by third parties on account of alleged negligence, and (iv) loss caused by injury or death due to occupational accidents. As compensation they receive premiums. Generally, the liabilities of P&C companies are shorter than for life insurance companies and vary with the type of policy, while the timing and amount of any liability remains unknown. Since P&C liabilities are not interest rate sensitive, P&C companies, compared to life insurance companies, tend to invest a higher proportion of their funds in equities.

Portfolio Management Service

Discretionary schemes Non-discretionary schemes

Differences Between PMS and Mutual Funds

Minimum Investment Lock-in-Period

Exit Load
Fees Interaction with the Scheme Manager Customisation Transparency

Taxation
Information Availability

Hedge Funds
Hedge funds, like mutual funds, are vehicles of collective investment. However, there are some important differences between the two: While mutual funds are open to the general investing public, hedge funds are typically open only to wealthy individuals

and Institutional investors.

Mutual funds are heavily regulated entities, whereas hedge funds are only lightly regulated.

Hedge fund managers can engage in leverage, short sales,

and heavy use of derivatives across various markets, whereas mutual fund managers cannot.

Hedge Fund Strategies

Equity-based Strategies Long-short equity strategy Equity market neutral strategy Arbitrage-based Strategies Fixed income arbitrage Convertible arbitrage Merger (risk) arbitrage Opportunistic Strategies High yield and distressed strategy Global macro strategy Managed futures Special situations

Three Errors of the Investment Management Industry

1. Falsely defined mission 2. Incorrect ordering of priorities 3. Lack of rigour in counseling

Summary
In recent decades the role and importance of professional asset management and institutional money management has grown significantly. Instead of managing your money yourself, you can entrust your money to a professional manager. Availing the services of a professional money manager may involve (a) establishing a private account with an investment advisor or (b) buying shares of an established security portfolio which is managed by an investment company.

The major institutional investors are insurance companies, banks, pension funds, endowment companies, and investment companies. The nature of liabilities differs from institution to institution and therefore is the key determinant of the asset mix to be included in the portfolio.

The primary goals of a financial institution are to earn an adequate return on funds invested and maintain a comfortable surplus of assets in excess of liabilities. Three types of surpluses may be calculated by institutions: economic surplus, accounting surplus, and regulatory surplus. Financial securities held by institutional investors are classified into three categories: (a) held-to-maturity, (b) available for sale, and (c) held for trading. Typically, hedge funds seek to exploit transient misalignments in security valuations. They buy securities that appear to be relatively underpriced and sell securities that appear to be relatively overpriced.

Hedge funds pursue a wide range of strategies, the more popular ones being the following: equity based strategies, arbitrage based strategies, and opportunistic strategies.