Common Characteristics
Note the following five common characteristics that cause institutional investors to differ from individual investors:
- Scale (size). Institutions tend to be larger than individual investors. The largest institutions may be too large for investments or managers with low capacity, such as small-cap equity or venture capital. These large institutions may therefore choose to directly access investments and manage them in-house. Smaller institutions may have issues diversifying across asset classes that have high minimum investment sizes (e.g., private equity or real estate). They may also face issues with hiring skilled investment professionals and instead choose to outsource to external managers and consultants.
- Long-term investment horizon. With some exceptions, institutional investors tend to have longer time horizons than individual investors because institutional investors are driven by the need to meet specific liabilities that are relatively low.
- Regulatory framework. Institutions are subject to different legal, regulatory, accounting, and tax rules than individual investors with the differences among institutional investors based on national jurisdiction.
- Governance framework. Institutions typically operate under a formal governance structure, whereas governance structures for individuals tend to be less formal. Governance structures are typically composed of a board of directors and an investment committee, which may be a subcommittee of the board. The board often sets the long-term strategic asset allocation of the institution, with the board and/or investment committee establishing the IPS and monitoring investment performance. The investment committee oversees investment policy. Investment strategy is implemented by an investment office typically headed by a chief investment officer; the investment management takes place either in-house by internal investment staff or is outsourced to external asset managers.
- Principal-agent issues. The principal-agent conflict occurs when a principal appoints an agent to act on their behalf and the agent’s interests are not aligned with the principal’s interests. For institutions, this conflict occurs internally through the appointment of the investment committee and investment staff and occurs externally through the use of outsourced investment managers.
Investment Policy Statement
The IPS should include:
- The institution’s mission and investment objectives (i.e., return and risk tolerance).
- Discussion of the investment horizon and liabilities that need to be paid by the institution.
- External constraints that affect the asset allocation (legal, regulatory, tax, and accounting).
- An asset allocation policy (i.e., portfolio weights) with ranges and asset class benchmarks.
- A rebalancing policy.
- Reporting requirements.
The IPS should be reviewed annually, and revisions should be made when necessary due to material changes in investor circumstances and/or market environment.
While each institution has unique features, four models have evolved as different general approaches to asset allocation. Three of these models are named after approaches used by Norway’s sovereign wealth fund, the Yale University endowment, and the Canada Pension Plan, while the fourth model is liability driven.
| Model | Description |
|---|---|
| Norway’s sovereign wealth fund | Passively managed allocation to public equities and bonds (with traditional 60% equity/40% bonds base case allocation) Little or no exposure to alternative assets Tight tracking error limits Low costs and fees Easy for board to comprehend No opportunity for outperformance of markets |
| Yale University endowment | High allocation to alternatives Significant active management Externally managed assets Potential for outperformance of markets Difficult for small institutions without expertise in alternatives May also be difficult for large managers due to capacity issues of external managers High fees/costs |
| Canada Pension Plan | High allocation to alternatives Significant active management Internally managed assets Uses a reference portfolio of passive public assets as benchmark that can be easily understood/communicated Potential for outperformance of markets and development of internal capabilities Potentially expensive and difficult to manage |
| Liability driven | Focus is on maximizing expected surplus (assets − liabilities) return and managing surplus volatility Explicitly recognizes liabilities as part of investment process Certain risks of liabilities (e.g., longevity) are difficult to hedge |