Defined Benefit vs Defined Contribution

This reading introduces the portfolio approach, the three steps of the portfolio management process, the needs of different types of investors, the difference between defined contribution and defined benefit pension plans, and the asset management industry with its pooled investment vehicles.

LOS 89.a — The portfolio approach to investing

Under the portfolio approach (also called the portfolio perspective), every candidate investment is judged by what it adds to, or takes away from, the risk and return of the investor's whole portfolio. The alternative is to study the risk and return of each security on its own and to ignore how it fits with everything else the investor owns. An investor who puts all of her savings in the one stock she believes is "the best" is not using the portfolio perspective. She carries far more risk than someone holding a diversified mix of stocks.

• Diversification lets an investor cut portfolio risk without necessarily giving up expected return. It mainly narrows the spread of outcomes, making very high and very low returns both less likely. It is not a tool for raising expected return.
• Modern portfolio theory (MPT) concludes that the extra risk of holding a single security, which could have been diversified away, is not rewarded with a higher expected return.
• Harry Markowitz (early 1950s) used the standard deviation of returns as the measure of risk and showed how combining risky assets changes portfolio risk and expected return. His key result: unless the assets' returns are perfectly positively correlated, combining them reduces risk.
• In the 1960s, Treynor, Sharpe, Mossin and Lintner extended this work into MPT, in which equilibrium expected returns are a linear function of market risk, the part of risk that diversification cannot remove.

Measuring the benefit: the diversification ratio

The denominator is the average standalone risk of the securities in the group.

Two caveats apply. First, an equally weighted portfolio is only a convenient yardstick; optimization software can find the weights that give the lowest standard deviation for the group. Second, diversification works best in normal markets. In a financial crisis, such as the credit contagion of 2008, correlations tend to rise, so diversification protects less at the very time it is most wanted.

LOS 89.b — The three steps of the portfolio management process

The IPS is the foundation of the whole process, so writing the IPS comes first. It should be reviewed at least every few years and whenever the client's objectives or constraints change significantly. Recent portfolio performance is not a reason to revise it.

Top-down versus bottom-up analysis (both belong to execution)

• Top-down analysis works from the broad to the specific. It starts with the macroeconomic picture: forecasts of GDP growth, inflation and interest rates, and the stance of government policy such as fiscal policy (spending and taxes) and monetary policy. From this the manager decides which asset classes look most attractive. The resulting portfolio is usually spread across publicly traded equities, fixed-income securities, cash, private equity, hedge funds, real estate, and commodities and other real assets. Within an asset class the analysis then narrows to industry analysis and only after that to company analysis. Industry analysis comes first because an industry's outlook shapes the results of the firms in it.
• Bottom-up analysis starts with individual securities: analysts use valuation models to find securities that look undervalued.

LOS 89.c — Types of investors and their needs

• Individual investors save for goals such as a home, children's education or retirement. Many countries offer tax-deferred retirement accounts, and defined contribution pension plans are a popular vehicle. Their needs depend entirely on the individual.
• An endowment is a fund dedicated to supporting a specific purpose on an ongoing basis, such as a university's programs. A foundation is a fund set up for charitable purposes, such as supporting research on a disease. A typical aim is to fund the activity indefinitely without eroding the real (inflation-adjusted) value of its assets.
• A bank aims to earn more on its loans and investments than it pays on deposits. It keeps risk low and needs liquidity to meet depositor withdrawals.
• Insurance companies invest premiums to pay claims as they arise. Life insurance companies have a relatively long horizon. Property and casualty (P&C) insurance companies have a shorter one because their claims tend to come sooner.
• Investment companies, such as mutual funds, manage pooled money in a particular style or segment of the market.
• Sovereign wealth funds are pools of assets owned by a government.

A defined benefit plan's income need depends on its participants' ages: a plan whose members are mostly retired and drawing benefits needs more current income than one whose members are mostly young workers.

LOS 89.d — Defined contribution versus defined benefit pension plans

LOS 89.e — The asset management industry

The asset management industry consists of firms that manage investments for clients. They are buy-side firms. Broker-dealers and investment banks, by contrast, are sell-side firms. Asset managers may be independent or divisions of larger financial groups.

Active versus passive management

• Active management tries to beat a chosen benchmark by relying on the manager's skill, using, for example, fundamental or technical analysis.
• Passive management tries to replicate a benchmark index, either by tracking a broad market index or through a smart beta approach that targets exposure to a particular risk factor.
• Passive management accounts for roughly one-fifth of assets under management (AUM). Passive fees are lower, so passive management's share of industry revenue is smaller still than its share of AUM.

Industry trends

• The market share of passive management has been growing. Lower fees help, as do doubts about whether active managers add value after risk adjustment, especially in developed markets thought to be fairly efficient. Most AUM is still actively managed.
• Profit margins are higher in alternative asset classes, so many traditional managers have moved into alternatives, blurring the line between the two types.
• The volume of available data has grown enormously, pushing managers to spend on information technology and on data services bought from third parties.
• Robo-advisors use computer algorithms to give advice based on an investor's requirements and constraints. They appeal to younger investors and smaller accounts, and they have lowered barriers to entry into asset management, for example for insurance companies.

LOS 89.f — Mutual funds and other pooled investments

A pooled investment is a single portfolio holding money from many investors; each investor owns shares in the pool. The net asset value (NAV) per share is

Open-end versus closed-end funds

• Open-end fund: investors buy newly issued shares at NAV and can redeem shares at NAV by selling them back to the fund, so the number of shares changes with investor demand. New cash is invested in more portfolio securities.
• Closed-end fund: a fixed number of shares. The fund neither takes new money nor redeems shares. The shares trade like stocks, on an exchange or over the counter. Because the price depends on supply and demand for the shares, the market price can differ significantly from NAV (a premium or discount).
• All mutual funds charge an ongoing management fee expressed as a percentage of NAV. No-load funds charge no purchase or redemption fees; load funds charge up-front fees, redemption fees or both.

Types of mutual funds

• Money market funds hold short-term debt securities. They pay interest income, and the chance that the share value changes is very small. NAV is typically held at one unit of currency per share, although some funds' NAVs have fallen in stressed markets.
• Bond mutual funds hold fixed-income securities and differ by maturity, credit rating, issuer and type (government, tax-exempt, high-yield, global).
• Stock mutual funds include index funds, which are passively managed to match an index, and actively managed funds, which select securities to beat their benchmarks. Actively managed funds charge higher fees and have higher turnover, which creates higher tax liabilities than index funds.
• Balanced (hybrid) funds hold both debt and equity securities.

Other pooled vehicles

• A separately managed account (SMA) is a portfolio owned by a single investor and managed to that investor's needs; no shares are issued. It suits investors with substantial assets and carries an annual fee based on assets.
• Hedge funds are far less regulated than mutual funds. They limit the number of investors, often to qualified (accredited) investors, set high minimums (commonly $250,000 to $1 million) and are not offered to the general public. Typical fees are 2% of assets plus 20% of excess performance. They follow many strategies, often with leverage, short positions and derivatives. Examples are global macro funds and event-driven funds, which trade around corporate events such as mergers and acquisitions.
• Private equity (buyout) funds buy all the shares of a company, often a public one, and take it private, usually financing a large percentage of the purchase price with debt. They restructure the company to raise cash flow and typically exit within three to five years, for example through an initial public offering (IPO) or a sale.
• Venture capital funds resemble buyout funds but invest in start-up companies, usually taking equity stakes with little borrowed money and providing advice and expertise. Both buyout and venture capital managers take an active role in managing the companies they own.