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. Individuals define risk as “losing money,” whereas institutions define risk

in terms of “standard deviation of return.”2. Individuals can be categorised by their personalities (or psychographics)

whereas institutions can be categorised by the investment characteristics of their beneficiaries.

3. Individuals enjoy great freedom to invest the way they want, whereas institutions are subject to various legal con straints.

4. 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. 5. 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.  

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

Risk ExamplePrice risk The market price of the asset falls Default risk The issuer of the asset is unable to meet its

obligations Inflation risk Due to inflation, the real value of the asset is

erodedExchange rate risk Due to a change in exchange rate, the value of a

foreign-denominated asset falls Reinvestment risk The cash flow received from an asset has to be

invested in a similar asset that offers a lower return

Liquidity risk An asset cannot be sold easily at a fair priceCall risk The issuer of an asset exercises its right to

redeem the asset prematurely

Nature of Liabilities

Liability Type

Amount of Cash Outlay

Timing of Cash Outlay

Example

Type A Known Known Fixed rate deposit in a bank

Type B Known Uncertain A whole life assurance policy (non-participating)

Type C Uncertain Known A two-year floating rate certificate of deposit

Type D Uncertain Uncertain An automobile insurance policy

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 held-for-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 fund’s 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 fund’s 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 firm’s shareholders assume the risk of a

defined benefit pension plan, the objective of the plan must be

consistent with the objective of the firm’s 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.

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.

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