The Trustee Guide to Investment

602 Pages·2011·5.61 MB·English

by  Andrew Clare, Chris Wagstaff (auth.)

The Trustee Guide to Investment
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The Trustee Guide to
Investment
Andrew Clare
and
Chris Wagstaff
© Andrew Clare and Chris Wagstaff 2011
All rights reserved. No reproduction, copy or transmission of this
publication may be made without written permission.
No portion of this publication may be reproduced, copied or transmitted
save with written permission or in accordance with the provisions of the
Copyright, Designs and Patents Act 1988, or under the terms of any licence
permitting limited copying issued by the Copyright Licensing Agency,
Saffron House, 6–10 Kirby Street, London EC1N 8TS.
Any person who does any unauthorized act in relation to this publication
may be liable to criminal prosecution and civil claims for damages.
The authors have asserted their rights to be identified as the authors of this work
in accordance with the Copyright, Designs and Patents Act 1988.
First published 2011 by
PALGRAVE MACMILLAN
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire RG21 6XS.
Palgrave Macmillan in the US is a division of St Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States,
the United Kingdom, Europe and other countries.
ISBN 978-1-349-31893-3 ISBN 978-0-230-36187-4 (eBook)
DOI 10.1057/9780230361874
This book is printed on paper suitable for recycling and made from fully
managed and sustained forest sources. Logging, pulping and manufacturing
processes are expected to conform to the environmental regulations of the
country of origin.
A catalogue record for this book is available from the British Library.
A catalog record for this book is available from the Library of Congress.
10 9 8 7 6 5 4 3 2 1
20 19 18 17 16 15 14 13 12 11
Contents
Acknowledgements xiii
Introduction xiv
1 The Pension Promise: How Do Pension Liabilities Arise? 1
Learning outcomes 1
Who believes in the pension fairy? 1
Defined benefit pension arrangements 2
Defined benefit summary 10
Defined contribution pension arrangements 11
Defined contribution default funds and lifestyling 15
Defined contribution starting to dominate the pensions landscape 19
The shape and size of the pension industry 21
Key points 22
2 Trustee Knowledge and Understanding and Investment
Governance: What Do Trustees Need to Know? 25
Learning outcomes 25
Trustee knowledge and understanding 25
Investment governance 29
Investment governance for defined contribution schemes 32
Summary 34
Key points 34
3 The Main Parties Trustees Deal with on Funding and
Investment Issues: Who are the Main Pension Players? 37
Learning outcomes 37
Introduction 37
The Pensions Regulator (tPR) 38
The sponsor 39
The covenant consultant 40
The Pension Protection Fund (PPF) 42
The pensions manager 43
The scheme secretary 43
The scheme actuary 43
The investment consultant 45
The fund managers 46
v
vi Contents
The de-risking consultant 47
The scheme lawyer 47
The custodian 48
The investment banks 48
The scheme auditor 48
The professional independent trustee 49
Key points 49
4 The Macroeconomic Background to Pensions:
Why Economics Matters 51
Learning outcomes 51
What is economics? 51
Growth 52
Inflation 61
Macroeconomic policy 69
The ‘state of the art’: Inflation targeting 72
The price of inflation targeting 74
Fiscal policy 75
Summary 77
Key points 77
5 Cash: The Most Liquid of All the Asset Classes 79
Learning outcomes 79
Introducing traditional asset classes 79
Introducing cash 80
Cash deposits 81
The money markets 82
Money market funds 84
Key points 85
6 Bonds: The Asset Class Trustees Fear the Most 87
Learning outcomes 87
Introduction 87
Bond characteristics 88
The cash flow from plain vanilla bonds 89
The global bond market 90
Bond types 93
Corporate bonds and credit risk 97
The price of a bond 101
Bond prices and returns 103
Duration – the key bond risk parameter 105
Contents vii
Yield curves and the yield curve family 111
Zero coupon, spot or cash rates 112
Forward interest rates and the forward yield curve 116
The relationship between forward and zero coupon curves 119
What factors determine the shape of the yield curve? 120
Summary 124
Key points 124
7 Equities: The Traditional ‘Growth’ Asset Class 125
Learning outcomes 125
Introduction 125
What are equities? 126
The structure and size of the world’s equity markets 128
Analyzing ordinary shares 132
Equity investment styles 139
The Dividend Discount Model (DDM) 143
Equity returns – the importance of dividends 150
Longer term equity valuation metrics 152
Key points 153
8 Real Estate: Putting Your Faith in Bricks and Mortar 155
Learning outcomes 155
Introduction 155
Distinguishing features 156
The case for real estate 158
Investing in real estate 160
Investment styles 167
Real estate market sectors 167
Investing globally in real estate 172
Concluding comments 174
Key points 174
9 Risk and Risk Management: Trustees as Risk Managers 175
Learning outcomes 175
Risk is one word but not one number 175
Not so ‘modern portfolio theory’ 177
Measuring risk 177
Interpreting standard deviation 179
Covariance and correlation 181
Diversification 183
Efficient portfolios 186
viii Contents
Reward and risk 189
T he Capital Asset Pricing Model (CAPM) and risk-adjusted
returns 191
Value at Risk (VaR) 197
Quantitative risk measures summary 201
Other, less quantifiable risks 201
Soft risks 205
Summary: A word of warning 207
Key points 209
10 Asset Allocation: The Big Decision 211
Learning outcomes 211
Introduction 211
Asset allocation in practice 212
Strategic asset allocation 214
Long-term expected returns 216
The expected, riskless real return 216
Expected inflation 218
The expected return on cash 220
Risk premia 221
Index-linked government bonds 222
Conventional government bonds – the inflation risk premium 222
Summary so far 225
Corporate bonds – the credit risk premium 225
Equities – the equity risk premium 228
Putting it all together 230
Volatility and correlations 231
P utting it all together to produce a strategic investment
portfolio 234
Strategic versus tactical asset allocation 235
Strategic asset allocation summary 237
A tactical asset allocation process 237
Asset allocation summary 247
Key points 248
11 Derivatives: Instruments of Mass Destruction? 249
Learning outcomes 249
Introduction 249
Forwards and futures 250
Hedging with futures 253
Closing out 254
Contents ix
Futures margins 255
Equity index futures contracts 256
Long bond futures contracts 259
Options 263
Credit default swaps 272
CDSs as insurance 273
CDS payments 275
CDS maturities 275
Trading CDSs 276
Issues with respect to CDSs 277
Summary 278
Key points 278
12 Interest Rate and Inflation Swaps: Swapping Payments
You Don’t Want for Those That You Do 279
Learning outcomes 279
Introduction 279
Swap basics 281
What is the swap rate? 286
Inflation swaps 289
Using swaps to transform cash flow profiles 292
The investment context of interest rate and inflation swaps 301
Summary 302
Key points 302
13 Alternative Asset Classes: An Alternative to What? 305
Learning outcomes 305
Why invest in alternative asset classes? 305
The Yale Endowment Fund 308
Risk and return 310
Hedge funds 311
Private equity 323
Commodities 331
Foreign exchange 336
Integrating alternatives with traditional asset classes 341
Summary 344
Key points 345
14 Portfolio Management: Analyzing and
Generating Returns 347
Learning outcomes 347
Introduction 347