LO 68.3: Describe the investment process of large investors such as pension funds.

LO 68.3: Describe the investment process of large investors such as pension funds.
‘The first step in the investment process is to determine the long-term, strategic asset allocations. Usually, the goal of the first step is to balance returns and risks using methods like mean-variance portfolio optimization. This step determines the allocations to asset classes such as domestic and foreign stocks, domestic and foreign bonds, and alternative investments such as real estate, venture capital, and hedge funds. Making this allocation relies on passive indices and other benchmarks to help measure the properties of the investment, and the availability of passive indices helps make the allocations feasible.
The second step in the investment process is to choose the managers who may either passively manage the fund (i.e., simply track the benchmarks) or actively manage the fund in an effort to outperform the benchmarks. The investors should review the managers activities and performance periodically. Their activities should conform to a list of guidelines, which includes the types of investments and risk exposure restrictions such as beta and duration. Managers performance can be evaluated by analyzing their tracking error.
VaR risk management systems are beginning to become more important because of the globalization of available investments and the increased complexity of investments. Also, investment companies are becoming more dynamic, which makes it more difficult to assess risk. With many managers, for example, each of the managers may make changes within his constraints, but the collective changes could be difficult to gauge with historical measures. In sum, because of increased globalization, complexity, and the dynamic nature of the investment industry, simply measuring risk using historical measures is no longer adequate, which has increased the need for VaR.
2018 Kaplan, Inc.
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Topic 68 Cross Reference to GARP Assigned Reading – Jorion, Chapter 17
H e d g e Fu n d Is s u e s

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