The most vital decision regarding investing that an investor can make involves the amount of risk he or she is willing to bear. Most investors will want to obtain the highest return for the lowest amount of possible risk. However, there tends to be a trade-off between risk and return, whereby larger returns are generally associated with larger risk. Thus, the most important issue for a portfolio manager to determine is the client’s tolerance to risk. This is not always easy to do as attitudes toward risk are personal and sometimes difficult to articulate.
The concept of risk can be difficult to define and to measure. Nonetheless, portfolio managers must take into consideration the riskiness of portfolios that are recommended or set up for clients.
This chapter assesses some of the constraints facing investors. An analysis of risk will be covered in the next chapter. Also, the main players in the money management business are reviewed. Investment institutions manage and hold at least 50% of the bond and equity markets in countries such as the USA and the UK. Thus, these institutions collectively can wield much influence over the money management industry, and potentially over stock and bond prices and even over company policies. The importance of one or another type of institutional money manager will vary from country to country. Finally, this chapter describes the most important investment vehicles available to these players.
Constraints
The management of customer portfolios is an involved process. Besides assessing a customer’s risk profile, a portfolio manager must also take into account other considerations, such as the tax status of the investor and of the type of investment vehicle, as well as the client’s resources, liquidity needs and time horizon of investment.
Resources
One obvious constraint facing an investor is the amount of resources available for investing. Many investments and investment strategies will have minimum requirements. For example, setting up a margin account in the USA may require a minimum of a few thousand dollars when it is established. Likewise, investing in a hedge fund may only be possible for individuals who are worth more than one million dollars, with minimum investments of several hundred thousand dollars. An investment strategy will take into consideration minimum and maximum resource limits.
Tax status
In order to achieve proper financial planning and investment, taxation issues must be considered by both investors and investment managers. In some cases, such as UK pension funds, the funds are not taxed at all. For these gross funds, the manager should attempt to avoid those stocks that include the deduction of tax at source. Even though these funds may be able to reclaim the deducted tax, they will incur an opportunity cost on the lost interest or returns they could have collected had they not had the tax deducted. Investors will need to assess any trade-offs between investing in tax-fee funds and fully taxable funds. For example, tax-free funds may have liquidity constraints meaning that investors will not be able to take their money out of the funds for several years without experiencing a tax penalty.
The tax status of the investor also matters. Investors in a higher tax category will seek investment strategies with favourable tax treatments. Tax-exempt investors will concentrate more on pretax returns.
Liquidity needs
At times, an investor may wish to invest in an investment product that will allow for easy access to cash if needed. For example, the investor may be considering buying a property within the next twelve months, and will want quick access to the capital. Liquidity considerations must be factored into the decision that determines what types of investment products may be suitable for a particular client. Also, within any fund there must be the ability to respond to changing circumstances, and thus a degree of liquidity must be built into the fund. Highly liquid stocks or fixed-interest instruments can guarantee that a part of the investment portfolio will provide quick access to cash without a significant concession to price should this be required.
Time horizons
An investor with a longer time horizon for investing can invest in funds with longer-term time horizons and can most likely stand to take higher risks, as poor returns in one year will most probably be cancelled by high returns in future years before the fund expires. A fund with a very shortterm horizon may not be able to take this type of risk, and hence the returns may be lower. The types of securities in which funds invest will be influenced by the time horizon constraints of the funds, and the type of funds in which an investor invests will be determined by his or her investment horizon.
Special situations
Besides the constraints already mentioned, investors may have special circumstances or requirements that influence their investment universe. For example, the number of dependants and their needs will vary from investor to investor. An investor may need to plan ahead for school or university fees for one or several children. Certain investment products will be more suited for these investors. Other investors may want only to invest in socially responsible funds, and still other investors, such as corporate insiders or political officeholders, may be legally restricted regarding their investment choices.
Types of investors
Investors are principally categorized as either retail investors, who are private individuals with savings, or institutional investors, which include banks, pension funds and insurance companies.
Retail investors
Many retail investors do not have the time, skill or access to information to assess the many investment opportunities open to them and to manage their money in the most effective manner (although, with the abundance of financial and company information now available on the Internet, more individuals are taking the control of their financial management into their own hands). In practice, few individuals have sufficient money to build up a portfolio which diversifies risk properly. As a result, a variety of organizations, all professional intermediaries or middlemen, have developed a range of investment products and services for retail investors. These organizations range from small, independent firms of financial advisers (IFAs) who advise investors on how best to invest their funds in return for commissions from major financial organizations, to larger institutions such as banks, life assurance companies, fund management groups and stockbrokers.
By pooling individual investors’ funds in various collective investment schemes, these intermediaries can (i) offer good returns at relatively low levels of risk; (ii) utilize the services of full-time, professional fund managers with access to the latest information; (iii) offer economies of scale in managing and administering the funds; (iv) minimize risk by investing in large, well diversified portfolios; and (v) depending on the particular product, provide a reasonable degree of liquidity, enabling the investor to buy or sell investments easily.
High net worth individuals will generally have more investment options available and can obtain specialized money management services. The professionals managing retail investor money or private client funds can offer the following services:
➤ Execution only service, which does not involve any advice or recommendations to the client but simply offers the means to buy and sell securities or assets for a commission. Very often, experienced financial investors who have the time and expertise to manage their own investment portfolios will choose this route.
➤ Advisory dealing service, which involves the stockbroker executing the business on behalf of the client, but also providing necessary advice regarding the transactions.
➤Portfolio advisory service, whereby a stockbroker will assess the client’s overall financial situation and needs and will provide advice on portfolio construction and investment strategy. However, it will be the client who gives the final word on the execution of the strategy.
➤ Portfolio discretionary service, where the stockbroker is responsible for the client’s portfolio and is free to buy and sell assets on behalf of the client according to market conditions and other limitations that have been pre-arranged.
The objectives and structure of private client funds will vary depending on the needs and circumstances of the client. Generally, younger clients can afford to take more risk in their portfolios given their longer investment time horizon. Retired clients will most likely take less risk in their portfolios in order to preserve principal and income. For example, a younger retail investor may require life assurance-linked savings products to facilitate a house purchase, while older investors may seek high-yielding gilts and certain equity-related products to provide income and protection against inflation during their retirement.
Institutional investors
Similar to retail or private clients, many institutions or corporations, large and small, can decide to outsource the management of their proprietary Treasury portfolios, company pension schemes, or client portfolios to a third party. Institutional clients are particularly attractive to professional money management organizations, as they usually represent long-term relationships with clients who invariably possess a large volume of assets. As with private clients, the services that can be provided to institutional clients range from execution-only to full discretionary services. Institutional
investors also include charities and other organizations such as certain universities, colleges and church commissioners.
The outsourcing of money management to external organizations has led to the growth of the consultant business. Consultants act as intermediaries helping institutions to select appropriate external money managers. The process usually involves assessing a parade of potential money managers’ investment philosophies and styles, fee structures, past performances, personnel, and systems. The financial institutions contending for the business often have to fill out questionnaires and give presentations to the company outsourcing. The consultants will help develop the criteria by which the contenders are judged and will summarize the weaknesses and strengths of each for their client. In the end, the outsourcing company will make the final choice of which group it would like to manage its money and will then become that company’s institutional client.
Banks
The core business of banks and building societies is to collect deposits and lend the money at a higher rate of interest. To optimize the return on these deposits banks invest in a range of money market and debt instruments, ranging from short-term Treasury bills to certificates of deposit to gilts and bonds, each with differing maturity profiles and liquidity. Since (in general terms) the longer the maturity the higher the rate of interest, sophisticated techniques are used by banks in order to create their desired portfolios and manage their assets/liabilities efficiently.
Many banks are also in the business of offering portfolio management alternatives to their retail clients. Retail investors may opt to keep part of their savings in unit trusts instead of in deposit accounts, particularly during periods where interest rates are low and stock market indices are rising. The managing of high net worth individual money (wealth management) is also a growth business for banks, and banks can offer institutional clients money management services. Over the years, investment management has been considered a growth business for banks, particularly in Europe. Portfolio management is a service that can be offered to existing clients in order to retain them as bank clients, and as a springboard for cross-selling other
products to them. Money management services can also be used to acquire new clients. In all, portfolio management is considered a good fee-earning business for banks.
Insurance companies
Insurance companies bear risk. In return for receiving a set premium payment on a set schedule from the policyholder, the insurance company will pay out a predetermined amount to settle a claim if a specified event happens. The premiums are invested until a claim is made on the policy.
Insurance company activities can be divided into two categories: general insurance business and life assurance business. General insurance business offers insurance cover against specific contingencies such as fire, accident and motor insurance. These policies are normally reviewed annually. Liabilities from this type of insurance business are usually short term in nature, since most claims are made immediately after a relevant event has taken place. Thus the bulk of the funds of these general insurance companies is invested in cash and short-term debt instruments to match these short-term liabilities, with the balance invested in equities to achieve long-term growth.
Life assurance and, increasingly, permanent health insurance are mainly concerned with long-term business. Premiums are received from customers and these are invested and paid out to meet claims or when policies mature. The principal event, if insured against, is the death of the policyholder, in which case a lump sum will be paid to the deceased’s estate or to a bank or building society in order to pay off a mortgage if the policy has been thus assigned. Life assurance policies can be categorized as follows:
➤ Term assurance policies, where the life of an individual is covered over a specified period (usually ten years or more). If the individual survives the period, no payment is made.
➤ Whole life policies, where a policyholder’s life is insured until his or her death, whenever the death occurs.
➤ Endowment policies, where, in return for regular premiums, the policy will pay a fixed lump sum of money when a policyholder dies, or the same lump sum if a policyholder survives a pre-specified period of time.
Since insurance policies normally run for ten, twenty or more years, the funds tend to be invested predominantly in equities in order to provide long term growth in income and capital, combined with protection against inflation. The balance of the funds is usually invested in gilts.
The investment returns of life fund businesses are subject to both capital gains tax and income tax, and as a result life assurance portfolio managers will adjust their investment strategies accordingly to minimize the tax paid on their funds. Life assurance premiums are paid net of tax by policyholders.
Insurance companies in the UK are tightly regulated by the Department of Trade and Industry and may be restricted from investing in certain types of assets.
Pension funds
A pension scheme is a fund established to pay pension benefits to beneficiaries upon their retirement. A pension scheme is normally set up by an employer in an effort to attract or retain employees, but may be set up by local councils for their employees, unions or trade associations, or even by private individuals for themselves (normally referred to as pension plans).
Two main types of pension funds are prominent:
➤ Defined benefit, where the sponsor agrees to pay members of the scheme a pension equal to a predetermined percentage of their final salary subject to the number of years which the contributor has worked
➤ Defined contribution where contributions are used to buy investments and it is the return on these investments that will determine the pension benefits.
Contributions are made by employers and/or employees into the scheme, and these are then invested in order to build up a capital sum and to generate an income out of which pensions and other benefits are paid. The management of pension schemes may be wholly or partially delegated to fund managers, including banks, fund management groups or even life assurance companies.
The usual principal objectives of pension funds are to achieve the maximum rate of return in excess of inflation over the long term, to maintain a surplus (i.e. an excess of assets over projected liabilities calculated on an actuarial basis), and to be able to meet their liabilities as they fall due.
The investment policies of both private and institutional investors will be partially determined by their tax status. Pension funds are exempt from both income and capital gains tax, and contributions to a pension scheme are not taxable. Generally, pension funds have fairly long-term time horizons and are thus able to take on more risk. As a result, these types of funds can invest in slightly more speculative assets, such as equities and property with a smaller proportion invested in fixed interest securities.
Fund management companies
Fund management companies comprise another significant category of investment management player. These companies may be subsidiaries of banks, part of stockbroking groups, or independent companies that manage funds for retail investors and for institutional investors, including pension funds, insurance companies and charities.
Some institutional investors employ their own fund managers and outsource specialized parts of their portfolios, such as Japanese stocks, private equity or emerging markets, to specialist fund managers at fund management companies. Many small and medium sized pension funds completely subcontract the role of fund management to fund management companies.
Investment vehicles
Most investment management players will offer their clients collective investment schemes known as unit trusts and investment trusts. (Alternative investment vehicles, such as hedge funds and private equity, are also an option for certain qualified players). With these products, the professional money manager manages larger funds comprised of money pooled from a large number of smaller investors.
Unit trusts
A unit trust is an open-ended fund in which investors buy units representing their proportional share of the assets and income in the trust. The money invested in the fund is used to buy shares or bonds, depending on the investment objective of the unit trust. A unit trust is constituted under a Trust Deed between a fund manager and an independent trustee, usually a bank or large insurance company. The trust is not a separate legal entity but actually a legal relationship between the trustee as the legal owner of the trust’s assets (usually shares and/or bonds) and the investors who will benefit.
Units may be either income units (on which the trust’s income is paid out periodically) or accumulation units (where income is not paid out but is added to capital in the form of new units). As an open-ended fund, more units can be issued when investors want to buy or the number reduced when investors want to redeem. In the former case new investments in the fund can be purchased, and in the latter investments have to be sold. The price of each unit reflects the current value of the fund divided by the number of outstanding units.
In the UK and in certain other European countries, unit trusts are limited in the amount they can invest in any one security. Up to 10% of the fund may be invested in the shares of a single company up to the level of four such investments (i.e. 40% of the fund). After reaching this level, the fund can only invest 5% of the value of the fund in any further single investment. Another rule states that a unit trust may not hold more than 10% of the total voting share capital issued by a single company. Unit trusts tend to charge an annual management fee that is fixed as a percentage of the value of the fund. In some countries, such as in the UK, investors purchase units at an offer price and sell the units back to the unit trust manager at a lower bid price.
In the USA, the equivalent investment vehicle to a unit trust is a mutual fund. A mutual fund is a corporation owned by its shareholders. The shareholders elect a board of directors, who are responsible for hiring a manager to oversee the fund’s operations. Most mutual funds are created by mutual fund companies (also known as investment advisory firms). These firms may offer other financial services, such as discount brokerage as well as fund management.
Investment trusts
Another investment vehicle offered by money managers is the investment trust. First founded in the 1860s, investment trusts are companies specifically set up to invest in the shares of other companies. They offer both corporate and individual private investors a way to purchase a diversified portfolio of securities. Investment trusts are not trusts, but limited liability companies. All investment trusts are listed on the Stock Exchange (but not all investment companies are). An investment trust has a fixed number of shares, and is known as a closed end fund. It has a fixed capital structure, and can only raise more capital by having a rights issue or by borrowing. The share price is determined solely by supply and demand, and may not mirror the performance of the underlying investments made by the trust. Where the net asset value per share is higher than the share price, the share price stands at a discount to net asset value. In the reverse case, the share price trades at a premium to the net asset value of the investment trust.
An investment trust is managed by a board of directors, who determine the investment trust’s investment strategy, which is then carried out by the management of the investment trust. The objective of the investment trust’s board is to maximize the value of the investments and share price for its shareholders. The rules governing the activities of the investment trust state that a maximum of 15% of the trust can be invested in a single company. In addition, the managers of the investment trust will charge an annual fee for their management services.
Generally, the main form of share capital in which investment trusts invest are ordinary shares paying out income in the form of regular dividends and offering the possibility of a capital gain. Investment trusts that have more than one main class of share are called split capital trusts. These trusts will have at least two classes of shares that meet the needs of different investors. They are designed to split capital from income. Split capital trusts are structured to have a predetermined date for winding up and, until that date, the right to dividends and the right to capital growth are split between each class of shares.
Open-ended investment companies
As of 1997 a new type of collective investment vehicle was created in the UK, called an open-ended investment company (OEIC). OEICs are similar to unit trusts in that they are available to the general public, the number of units or shares can vary from day to day, and their price will reflect the value of the fund’s underlying portfolio. Also, they are subject to a similar regulatory regime as unit trusts. However, they resemble investment trusts in that they have a company structure, and the assets of the fund are overseen by a depository and not a trustee.
OEICs are meant to attract non-UK investors who are uncomfortable investing in the UK due to lack of experience with the trust concept. With OEICs, private investors will be allowed to move between different subfunds under a single OEIC – for example from UK income to UK growth. This is cheaper than moving between unit trusts. Also, OEICs will be able to issue different classes of shares, which will facilitate different fee structures and allow for shares denominated in different currencies.
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