of asset classes, including alternative assets, are available to them.
3. PRIVATE DEFINED CONTRIBUTION FUNDS. Private defined contribution fundsare set up to receive contributions made by the plan sponsor into the fund. The pension plan specifies the contributions that the plan sponsor is expected to make while the firm employs the beneficiary. The contributions are deposited into accounts that are tied to each beneficiary, and upon retirement, the employee receives the accumulated value of the account. The employee and the plan sponsor jointly manage the fund's assets, in that the sponsor decides on the menu of asset classes available, and the employee decides the asset allocation. The menu of asset classes available to these funds is smaller than both national funds and defined benefit funds. Lumpiness of alternative investments, lack of liquidity, and government regulations typically prevent these funds from investing in a full range of alternative asset classes. Historically, real estate is one alternative asset class that has been available to these funds. In recent years, liquid alternatives have slowly become available as well.
4. INDIVIDUALLY MANAGED ACCOUNTS. Individually managed accounts are no different from private savings plans, in which the asset allocation is directed entirely by the employee. Since the funds enjoy tax advantages, they are not free from regulations, and therefore the list of asset classes available to the beneficiary will be limited. In particular, privately placed alternative investments are not normally available to these funds.
1.3.3 Sovereign Wealth Funds
Sovereign wealth funds (SWFs) are funds set by national governments as a way to save and build on a portion of the country's current income for use by future generations of its citizens. SWFs are similar to national pension funds in the sense that they are owned and managed by national governments, but the goal is not to provide retirement income to the citizens of the country.
SWFs have become major players in global financial markets because of their sheer size and their long-term investment horizons. Most SWFs invest a portion of their assets in foreign assets. SWFs are relatively new, and their growth, especially in emerging economies, has been tied to the rise in prices of natural resources such as oil, copper, and gold. In some cases, SWFs are funded through the foreign currency reserves earned by countries that enjoy a significant trade surplus, such a China.
SWFs are large and have very long horizons; therefore the full menu of assets should be available to them. However, because national governments manage them, they may not invest in all available asset classes.
1.3.4 Family Offices
Family offices refer to organizations dedicated to the management of a pool of capital owned by a wealthy individual or group of individuals. In effect, it is a private wealth advisory firm established by an ultra-high-net-worth individual or family.
The source of income for a family office can be as varied as the underlying family that it serves. In some cases, the capital is spun off from an operating company, while in other cases, it might be funded with what is known as legacy wealth, which refers to a second or third generation of family members that have inherited their wealth from a prior source of capital generation. The financial resources of a family office can be used for a variety of purposes, from maintaining the family's current standard of living to providing benefits for many future generations to distributing all or a portion of it through philanthropic activities in the current generation. Family offices tend to have relatively long time horizons and are typically large enough to invest in a full menu of assets, including alternative asset classes.
1.4 Objectives and Constraints
As already discussed, different asset owners have their own particular objectives in managing their assets and face various constraints, which could be internal or external. An objective is a preference that distinguishes an optimal solution from a suboptimal solution. A constraint is a condition that any solution must meet. Internal constraints are imposed by the asset owner and may be a function of the owner's time horizon, liquidity needs, and desire to avoid certain sectors. External constraints result from market conditions and regulations. For instance, an asset owner may be prohibited from investing in certain asset classes, or fees and due diligence costs may prevent the owner from considering all available asset classes. The next sections describe the issues that must be considered while attempting to develop a systematic understanding of asset owners' objectives and constraints.
1.5 Investment Policy Objectives
Asset owners' objectives must be expressed in terms of consistent risk-adjusted performance values. In other words, it is safe to assume that asset owners would prefer to earn a high rate of return on their assets. However, higher rates of return are associated with higher levels of risk. Therefore, asset owners should present their objectives in terms of combinations of risks and returns that are consistent with market conditions and their level of risk tolerance. For instance, the objective of earning 30 % per year on a portfolio that has 8 % annual volatility is not consistent with market conditions. Such a high return would require a much higher level of volatility. Also, if the asset owner states that her objective is to earn 25 % per year with no reference to the level of risk that she is willing to assume, then it could lead the portfolio manager to create a risky portfolio that is entirely inconsistent with her risk tolerance. Therefore, asset owners and portfolio managers need to communicate in a clear language regarding return objectives and risk levels that are acceptable to the asset owner and are consistent with current market conditions.
1.5.1 Evaluating Objectives with Expected Return and Standard Deviations
Consider the following two investment choices available to an asset owner:
If an asset owner expresses a preference for investment A over investment B, then we can claim that the asset owner is risk averse. Although it is rather obvious to see why a risk-averse asset owner would prefer A to B, it will not be easy to determine whether a risk-averse investor would prefer C to D from the following example:
In this case, compared to investment C, investment D has a higher expected return (1.5 % to 1 %) and a higher standard deviation (10.5 % to 9 %). Depending on their aversion to risk, some asset owners may prefer C to D, and others, D to C.
1.5.2 Evaluating Risk and Return with Utility
Different
