Level 1 CFA® Exam:
Market Participants & Investment Products
This lesson is about:
- market participants and their needs and limitations involved in creating a portfolio of assets,
- the process of creating and managing a portfolio, and
- basic investment products.
Financial markets is a very broad topic. If we wanted to provide a definition of financial market, we could say it is a place (a real or abstract one) where transactions in financial instruments are conducted. In the financial market, its participants meet in order to exchange capital – they either acquire capital for themselves or provide others with money.
Basically, market participants can be divided into 3 groups:
- cash surplus entities, that is those that have capital – simply called investors,
- deficit entities that seek funding, and
- financial intermediaries, i.e. financial institutions that facilitate the contact between investors and entities seeking funding.
In this lesson we are going to focus on those financial entities that look for opportunities to invest and build their portfolio.
Investors can be divided into 2 main categories:
- individual investors and
- institutional investors.
Institutional investors will be of more interest to us and we will discuss financial entities such as pension plans, endowments, banks, insurance companies, and investment companies. We will also attempt to describe some common characteristics of individual investors.
Defined Benefit Pension Plans
As part of a defined benefit pension plan, employers are required to pay annual benefits to their retired workers. The manager of such a fund must adjust the time horizon of the portfolio to the age of an employee. A relatively long time horizon allows one to take a big risk. However, this risk should decrease with time, as the closer one gets to payments, the smaller the risk should become. Over time, there is also a need to pay pension benefits, which must be taken into account in the portfolio planning process. When funds are being collected, money cannot be withdrawn so liquidity may be low.
In terms of the four categories we’ve already mentioned for individual investors, pension plans will be defined as having high risk tolerance, long-term time horizon for investments, income needs depending on how long the fund operates and quite low liquidity needs.
University endowments and foundations are supposed to continue operating over long periods of time, which is why they are characterised by a long-term investment horizon that allows them to take a high risk. Income needs are differentiated depending on what objectives these institutions have. A long time horizon and some specific features of these entities allow them to have low liquidity. The main goal is, however, to maintain the real value of assets and generate income.
Banks, as a special kind of public trust institution, should not expose their funds to excessive risk. They have a short time horizon and have to invest in highly liquid assets in case the clients suddenly wish to withdraw their money. Income from funds managed by banks should cover the interest that they have to pay on their clients’ deposits.
So, in a nut shell, banks typically have low risk tolerance, short-term time horizon and rather high income and liquidity needs.
Insurance companies shouldn’t take any large investment risk either. They need to have high liquidity to ensure they meet their obligation to pay claims under insurance contracts. Income needs are mostly low, although this depends on the investment policy adopted by such an entity. In most countries there is a distinction between life insurance companies and non-life insurance companies, dealing for example with home insurance. Life insurance companies are characterized by a relatively long time horizon.
The objectives of investment companies, as in the case of individual investors, are very varied. Because such companies manage investment funds intended for a wide range of clients. And so they differ not only in key aspects, such as risk-taking or investment horizon, but also in many other things, including those related to the client's tax situation. So, again our four categories will vary depending on the company, just like in the case of individual investors.
Sovereign Wealth Funds
Sovereign wealth funds are special funds established and managed by a government to invest mainly in foreign assets. The fund’s money often comes from strategic and highly profitable sectors of an economy, such as the sale of crude oil and other commodities.
Managing an investment portfolio would not be possible without defining the tasks that fund managers have to fulfil. The investment process can be represented by 3 major steps:
- the planning step,
- the execution step, and
- the feedback step.
Each step includes some specified tasks. Let’s see in more detail how it works.
Each fund must be properly planned so that it is possible to manage it effectively and to call the fund manager to account for the results of his work. In the planning step you characterise your client and describe his need. As a manager you need to understand your client’s expectations. In other words, you need to know your client’s investment objectives, financial situation or his risk profile. These and many other investment characteristics should be written down and form the basis of an agreement between the client and the manager. This agreement is called an investment policy statement (IPS) and exists in similar forms in many countries.
This step consists of 2 substeps:
- monitoring the portfolio,
- assessing the performance of portfolio management.
First of all, we need to monitor the portfolio and introduce appropriate alterations in response to changing economic conditions and in order to adjust the portfolio to your clients requirements.
Second, you have to periodically assess the performance of portfolio management. This efficiency shows you how your portfolio performed over a certain period of time, usually in comparison with a benchmark, such as a stock market index or the inflation rate, etc. It is quite common that the manager’s compensation is based on how effectively he or she manages the portfolio. Apart from the evaluation of how effective the portfolio management was, also performance should be adequately summarized and presented to the investor.
If you want to satisfy your clients you have to find investment products satisfying their needs. That clients’ needs are varied is common knowledge and this is why there is a need for a wide range of investment products.
Mutual funds are based on the idea of a collective investment which dates back nearly 240 years. These funds were created for people who want to increase their savings, but don’t know enough about financial markets to invest their money safely. Currently, mutual funds are an important element of the whole financial system. They are used not only by individual investors but also by institutional ones.
For the investor, it is important that mutual funds pursue different investment strategies, ranging from safe investments in treasury bonds to investments in risky stocks. We should also take a look at an important division of mutual funds, used across the world, into closed-end funds and open-end funds.
An open-end fund issues shares in return for the money paid by investors. The fund sells and repurchases the shares whenever requested by the client. The total number of shares is changing and their price depends on the net asset value (NAV) per share. Anyone can invest in an open-end fund.
Shares issued by a closed-end fund, unlike shares issued by an open-end fund, are traded in the market. In the case of a closed-end fund, the number of shares doesn’t change.
Mutual funds differ also in terms of fees that you have to pay if you want to invest in the fund. Typically, there is one annual fee, which is based on a percentage of the fund’s net asset value and this is called a no-load fund. In the case of some funds, apart from the annual fee, there are also fees charged every time you want to invest in the fund or redeem from the fund and this is called a load fund.
Other Investment Products
As an alternative to investment funds, there are also products which are becoming more and more popular nowadays. These are:
- exchange traded funds (ETFs),
- separately managed account (SMAs),
- hedge funds,
- buyout funds, and
- venture capital funds.
Exchange Traded Funds
The objective of exchange traded funds is to track the way a stock index behaves. The effect is possible either by means of physical replication (which means the purchase of shares included in a given index to track the index) or by means of synthetic replication (this is when you hedge the ETF value using derivatives). ETF fund issues ETF shares, which, like shares or bonds, are traded on stock exchanges.
The advantages of ETFs are:
- low costs (which comes as a result of e.g. passive management),
- high liquidity.
- very often ETFs, compared to a typical index fund, have a lower initial payment required at the beginning of the investment and so they are attractive to less wealthy investors.
Separately Managed Accounts
Another investment opportunity is created by separately managed accounts where the manager decides on the portfolio’s construction together with the client. The investor has a significant influence on the portfolio and its assets. He can also count on support offered by professionals. The main disadvantage of such solutions is usually a high amount of initial investment.
Hedge funds differ from traditional mutual funds in that they don’t usually have to meet so many formal requirements (e.g. regarding information policy). These products are very often expensive but have a high profit potential as they involve high risk.
Buyout funds are funds that invest in public entities and transform them into private companies. These funds are actively involved in the restructuring process of acquired entities with regard to both financial and operational aspects. Typically, the objective of these funds is to resell the acquired company after several years from the moment of acquisition.
Venture Capital Funds
Venture capital funds on the other hand invest in promising new businesses. The project usually takes a few years and involves not only financial but also substantial help for acquired companies. Both buyout funds and venture capital funds require large initial amounts but offer a relatively high expected return on investment instead. The possibility of big profit is accompanied by high risk and limited liquidity.
Level 1 CFA Exam Takeaways: Market Participants & Investment Productsstar content check off when done
- Financial market is a place (a real or abstract one) where transactions in financial instruments are conducted.
- Individual investors have a wide range of expectations and investment limitations.
- As part of a defined benefit pension plan, employers are required to pay annual benefits to their retired workers.
- Banks typically have low risk tolerance, short-term time horizon and rather high income and liquidity needs.
- Sovereign wealth funds are special funds established and managed by a government to invest mainly in foreign assets.
- The investment process can be represented by 3 major steps the planning step, the execution step, and the feedback step.
- In the planning step you characterize your client and describe his need.
- Execution step consists of: asset allocation, analysis of particular securities or individual assets, and creating the portfolio.
- Feedback step consists of: monitoring the portfolio and assessing the performance of portfolio management.
- Shares issued by a closed-end fund, unlike shares issued by an open-end fund, are traded in the market.
- Money market funds are the most secure funds.
- In the case of money market funds the maturity of instruments rarely exceeds 90 days, while in the case of bond funds it can be even as long as 30 years.
- The objective of exchange traded funds is to track the way a stock index behaves.
- Buyout funds are funds that invest in public entities and transform them into private companies.
- Venture capital funds on the other hand invest in promising new businesses.