Ch 1: Asset Owners

Prof Andrew Ang

July 2014

Outline

● Common considerations

● Sovereign wealth funds (SWFs)

● Pension funds

● Foundations and endowments

● Individuals

2

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

4

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

5

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

6

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 principal’s 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.

7

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

9

Sovereign Wealth Funds

● Oldest SWF is Kuwait’s, 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 818UAE Abu Dhabi ADIA 773Saudi Arabia SAMA Foreign Holdings 676China CIC 575China SAFE Investment Holdings 568*Kuwait KIA 296Hong Kong HKMA 327Singapore GIC 285Singapore Temasek 173Qatar Qatar Investment Authority 170China National Social Security Fund 161Australia Australia Future Fund 89Russia National Welfare Fund 88Russia Reserve Fund 86Kazakhstan Kazakhstan National Fund 78Algeria Revenue Regulation Fund 77Korea KIC 72UAE Dubai Investment Corporation of Dubai 70Source: www.swfinstitute.org * = estimates

11

Growth of Sovereign Assets

12

Source: IMF COFER

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Foreign Exchange Reserves (Billions)

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 Chile’s Economic Stabilization Fund and Russia’s 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

17

Age

IncomeConsumption

Time

Income per capital

Consumption per capital

Spending Sovereign Wealth

● Spending rules take many forms. Norway’s example:

18

Oil revenue+ investment returns

GPFGNorway’s

SWF

Non-oil revenues

Government Budget

Expenditures

Spending rule(approx 4%)

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 worker’s 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

Data from Flow of Funds

21

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

0%

10%

20%

30%

40%

50%

60%

70%

80%

Proportion of Assets in Defined Benefit vs Defined Contribution Plans

% Defined Benefit % Defined Contribution

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).

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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

-$400,000

-$300,000

-$200,000

-$100,000

$0

$100,000

$200,000

0%

25%

50%

75%

100%

125%

150%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Funding Status of Top 100 Pension Funds

Funding Status (Billions RH Axis) Funding Ratio (LH Axis)

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 4-5% 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

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Endowment Returns and Spending Rates

Endowment Returns (LH axis) Spending Rates (RH axis)

Restricted Endowment

● Most endowment funds are restricted

32

Components of Total Endowment in 2011 (Billions) NACUBO

True Endowment 188.11 46%Donor-restricted 172.67 42%Unrestricted 15.44 4%

Term Endowment 16.88 4%Quasi-Endowment 92.44 23%Funds Held in Trust by Others 16.46 4%Other 94.24 23%

Total Endowment 408.13 100%

PercentBillions

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

0

0.1

0.2

0.3

0.4

0.5

0.6

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Endowment Allocation to Alternatives

Individuals

Middle Class, Rich, and Really Rich

● 2010 median annual household income: $46,0002010 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, doesn’t 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

40

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 investor’s bad times do not necessarily correspond to the market’s (average investor’s) 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”