Ch 1: Asset Owners

Prof Andrew Ang

July 2014

Outline

Common considerations

Sovereign wealth funds (SWFs)

Pension funds

Foundations and endowments

Individuals

Common Issues

Investors

Who?
Individual, collective owner (e.g. family or pension fund),
endowment/foundation, corporation, nation (e.g. sovereign wealth fund)

Why?
Liabilities, aims, and goals of the asset owner

What?
Properties of different assets to meet the goals of the asset owner

How?
Delegated portfolio management and principal-agent issues

Asset Owners
Despite the heterogeneity of asset owners, all share common issues

Preferences: How to measure how an investor cares about returns in different

states of the world. Some states (e.g. crashes) may be more painful than
others.

Risk Aversion: How much risk an investor can tolerate

Liabilities
Cash outflows can be contractual, like fixed liabilities, or endogenously
determined, like consumption

Income
Cash inflows can be zero in some cases, like some foundations

These are investor-specific characteristics

Asset Returns

Which assets should be held to best match the goals, utility, and risk tolerance
of the investor?

Different assets and investment strategies have different risk premiums and
risk characteristics. How is the risk-return relation determined in equilibrium?

Factor risk: exposure to factor risk determines risk premiums. Factors include
macro factors, like inflation and growth, as well as tradable investment styles,
or investment factors, like value-growth and momentum

The process of determining which assets to hold, given the characteristics of

the asset owner, is called asset allocation

Principal-Agent Issues

Asset owners generally do not invest on their own. They usually hire
intermediaries. This gives rise to an agency problem.

Principal: asset owner. Agent: delegated investment manager(s)

The principal and agent do not usually have the same goals. Usually, the agent
has incentives to deviate from the principals optimum.

How should a contract be structured?

How much should the intermediary be paid?

How to monitor the intermediary?

Certain investment vehicles, like private equity/venture capital, or hedge funds,

represent a certain style of contract between a principal and agent and access
particular types of risk premiums (like illiquidity risk, volatility risk, momentum
risk, etc). Private equity and hedge funds are not asset classes.

Sovereign Wealth Funds

Sovereign Reserves

There is no universally accepted definition of a SWF. SWFs are part of sovereign

savings, which include central bank reserves, commodity savings or stabilization
funds, pension reserves or social security funds, and government holding
management companies.

Working definition:
Investment fund controlled by a government and invested (partly or wholly) in
foreign assets

Sovereign Wealth Funds

Oldest SWF is Kuwaits, established in 1953

SWFs in the US, all at the state level:

New Mexico Severance Tax Permanent Fund, established 1973
Wyoming Permanent Mineral Trust Fund, established 1974
Alaska Permanent Fund, established 1976
Alabama Trust Fund, established 1985
North Dakota Legacy Fund, established 2011

Distinguishing characteristic is government ownership

10

Largest SWFs
Largest Sovereign Wealth Funds (USD billion) (Jan 2014) [SUSPECT!]
Norway
Government Pension Fund Global
818
UAE Abu Dhabi
ADIA
773
Saudi Arabia
SAMA Foreign Holdings
676
China
CIC
575
China
SAFE Investment Holdings
568*
Kuwait
KIA
296
Hong Kong
HKMA
327
Singapore
GIC
285
Singapore
Temasek
173
Qatar
Qatar Investment Authority
170
China
National Social Security Fund
161
Australia
Australia Future Fund
89
Russia
National Welfare Fund
88
Russia
Reserve Fund
86
Kazakhstan
Kazakhstan National Fund
78
Algeria
Revenue Regulation Fund
77
Korea
KIC
72
UAE Dubai
Investment Corporation of Dubai
70
Source: www.swfinstitute.org * = estimates
11

Growth of Sovereign Assets

Source: IMF COFER

12

Sovereign Reserves

SWFs are just one vehicle for holding sovereign wealth.

The line between reserves, SWFs, and state-owned companies is increasingly

blurred:
Central banks like Switzerland, SAFE (China), Norway hold equities and
risky assets closer to traditional SWFs.
Certain SWFs, like Chiles Economic Stabilization Fund and Russias
Reserve Fund, hold highly liquid, safe instruments closer to central banks.

IFSWF (www.ifswf.org) and the Santiago Principles

13

Sources of Wealth

Commodities
Petroleum prices went from US$20 in the late 1990s and reached a high of
US$147 in July 2008
Resource curse or Dutch disease

Trade surpluses
Domestic economies ill-equipped to absorb all inflows or leaders have
precautionary motives
Currency (mis-?)management: New Bretton Woods

Government budget surpluses or transfers

Global imbalances?

14

Impacts of SWFs

Although not new, the rise of SWFs over the last decade reflects two broader,
related geopolitical trends:

1 Redistribution of wealth away from the Western world (US, Europe, and other
mature developed economies) to the East and developing countries

2 An increasing role of governments in managing wealth, creating industrial

policy, and managing the economy

15

Consumption Smoothing

Some SWFs exist to allow governments to smooth spending over time

A sudden increase in wealth can be detrimental for welfare

Natural resource booms do NOT lead to long-run welfare growth: the
Dutch disease
Real exchange rates appreciate, causing traded sectors to be less
competitive
Resource bonanza increases corruption and wasteful government
spending, especially in emerging markets with poorly functioning institutions

Use a SWF to spread spending over time: life-cycle model

16

Consumption Smoothing

Modigliani and Brumberg (1954) life-cycle model and Ramsey (1928), Cass
(1965) and Koopmans (1965) neoclassical growth models

Consumption
per capital
Income
Consumption

Income
per capital

Time

Age
17

Spending Sovereign Wealth

Spending rules take many forms. Norways example:

Oil revenue
+ investment returns

GPFG
Norways
SWF

Non-oil revenues

Government
Budget
Spending rule
(approx 4%)
Expenditures

18

Pension Funds

Pension Funds

The main savings mechanism for individual investors for retirement are pension
funds. There are two main forms

Defined Benefit: Employer pays a benefit which is a predetermined formula of age,

tenure, and current and past wages. A typical payout at retirement looks like
constant x average of last 3 years salary x number of years of service. The majority
of government pension plans are defined benefit. Old style corporate pension
plans are defined benefit, but these are often closed to new members. Pension
payouts to retirees are often partially indexed to inflation.

Defined Contribution: Employer contributes a predefined amount. The retirement

account works like a bank balance and is invested at the workers discretion in a
variety of asset classes (like stocks, bonds, money market, etc.) The majority of new
corporate pension plans are defined contribution.

In defined benefit plans, the employer bears the risk of meeting retirement benefits
(the benefits are defined). In defined contribution plans, the worker bears the risk.
20

Defined Benefit Plans are Going the Way of the Dodo

Proportion of Assets in Defined Benefit

vs Defined Contribution Plans
80%
70%
60%
50%
40%
30%
20%
10%
0%
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
% Defined Benefit

% Defined Contribution

Data from Flow of Funds

21

ERISA

The Employee Retirement Income Security Act of 1974 (ERISA) provides minimum
standards for pension plans and taxation rules of pension benefits. ERISA has been
strengthened with subsequent regulation, most recently the Pension Protection Act
(PPA) of 2006. ERISA is often used to refer to all laws concerning pension
regulation.

ERISA does not require corporations to set up pension plans; it only regulates them
after their creation in two important areas
Minimum benefits. Employer contributions made after 2006 to a defined
contribution plan must become 100% vested after three years or 20% in year 2
increasing to 100% in year 6 [PPA]. Employee contributions are always 100%
vested.
Minimum funding. ERISA specifies that corporations must put sufficient money
into defined benefit plans to sufficiently meet their liabilities.
[Why is this not an issue with defined contribution plans?]

22

ERISA

Defined benefit plan liabilities are the present value of all projected payments from
the plan, and involve various assumptions on wage growth, inflation (benefits are
often indexed), mortality, morbidity etc. There are various liability measures
computed by actuaries:
Accumulated Benefit Obligation (ABO): PV of benefits owed to current
employees and retirees. This is the liability currently earned by employees.
Projected Benefit Obligation (PBO): Takes into account future expected salaries
of current employees, but does not count future benefits of new hires.

If the pension fund assets are greater than the ABO, the plan is over-funded and the
employer has to contribute the costs of benefits earned over the past year

If the pension fund assets are lower than the ABO, the plan is under-funded, and
ERISA requires contributions to bring the fund up to fully funded over seven years,
and additional contributions for at risk funds.

23

PBGC

The funding requirements under ERISA ensure that workers are likely paid the
benefits they accrue. However, even for a fully funded plan, there is still a
probability that the plan may fail.

The Pension Benefit Guaranty Corporation (PBGC) was created under ERISA to
protect beneficiaries of failed pension plans

If a company enters bankruptcy, the PBGC takes over the pension plans and
guarantees annual pensions to a maximum of $55,841 in 2012. The PBGC may
also takeover at-risk funds without bankruptcy. The PBGC receives any pension
plan assets and becomes an unsecured creditor for the unfunded benefits.

Pension plans pay premiums to the PBGC for this support. The premium is levied
per plan member. In 2012 the premiums are $9 per member for multiemployer
plans and $35 per member plus $9 for each $1000 of unfunded vested benefits for
single-employer plans (unchanged since 2010).

24

ERISA

Under ERISA, pension plan deficits constitute employer liabilities. Thus, cashflow
that could go to otherwise profitable investment opportunities may be forced to be
diverted to shore up pension plans. Rauh (2006) shows that cash drains from
required pension contributions reduce firm investment.

The PBGC benefit is a put option for employers, as first noted by Sharpe (1976).
Explicit values for the benefit are computed by Pennachi and Lewis (1994), among
others and it is considerable. The CBO (2005) estimates premiums have to be
increased by more than 6x to cover the PV shortfall from projected future claims
this does not include existing losses.

ERISA only covers corporate pension plans. Public pension plans are heavily
underfunded, with unfunded liabilities close to $1 trillion (Novy-Marx and Rauh
(2009)).

25

Pension Underfunding

26

Pensions: Challenges
The pension system world wide is facing severe challenges

Underfunding of pensions, particularly public pension plans, and/or of pension

guarantors (PBGC, etc). Poor performance of equities over the past 20 years
has contributed to underfunding.

Dramatic increases in longevity

Intergenerational (in-)equity

Defined contribution schemes place all risk on the employee, who is less able
to handle it. Defined contribution schemes are, on average, less generous
than defined benefit plans.

Ratio of workers to retirees (dependency ratio) is shrinking in developed

countries

27

Public Pension Reform

28

Foundations and Endowments

Payout Rules

Foundations are required to pay out at least 5% of AUM every year

established under the Tax Reform Act of 1969

University endowments are not constrained, but many pay out approximately 45% and only slowly change their payouts over time

Public endowments are much more transparent than private foundations

Private foundations are often used to control wealth, exempt from tax, and
so the government places restrictions to force them to pay out, rather than
cumulate, wealth

30

Payout Rules

31

Restricted Endowment

Most endowment funds are restricted

32

Relative Benchmarking

Universities compete with each other in terms of endowment performance

Endowment managers are benchmarked against each other

This causes herding, and is a form of keeping up with the Jones utility

Endowment allocations into private equity and hedge fund alternatives have
markedly increased, following Harvard-Princeton-Yale, who were the first
movers

33

Following the Yale Pied Piper

Large shift to alternatives: private equity and hedge funds

34

Individuals

Middle Class, Rich, and Really Rich

2010 median annual household income: $46,000

2010 median annual household wealth: $77,000

High-net worth: $1 to $10 million in assets

Ultra high-net worth: $10 to $30 million in assets

The really, really rich form family offices, operating much like endowments

36

(Rich) Family Dynamics

Conflicts

Nepotism
Just because he or she is family, doesnt mean that person should manage
the family firm or family office

Lack of diversification

Slouching
Families, just like nations, suffer from the Dutch disease

Spending too much

37

Middle Class Considerations

Labor income
Biggest asset is not financial wealth, it is human capital
Life-cycle considerations

Leverage
Housing is a very levered, illiquid asset for most people

Health care risk

Can be debilitating, hard to obtain complete insurance

38

Summary

Summary

Who?

Investor-specific characteristics give rise to bad times

Bad times depend on risk aversion, liabilities, income

What?

Which assets should be held to mitigate the risk of bad times

and to earn risk premiums?
An investors bad times do not necessarily correspond to the
markets (average investors) set of bad times

How?

Asset owners usually hire delegated managers

Watch that the principal-agent relation does not saddle you with
additional bad times

40