INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
30 April 2015 (am)

Subject SA6 Investment

Specialist Applications
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1.

Enter all the candidate and examination details as requested on the front of your answer
booklet.

2.

You have 15 minutes before the start of the examination in which to read the
questions. You are strongly encouraged to use this time for reading only, but notes
may be made. You then have three hours to complete the paper.

3.

You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

4.

Mark allocations are shown in brackets.

5.

Attempt all three questions, beginning your answer to each question on a new page.

6.

Candidates should show calculations where this is appropriate.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

SA6 A2015

Institute and Faculty of Actuaries

(i)

Describe what is meant by Quantitative Easing.

[5]

(ii)

Explain why Quantitative Easing might result in rising asset prices.

[6]

Following a severe recession in a developed country, the Central Bank initiated a

policy of Quantitative Easing to stimulate the economy and to revive economic
growth.
Several years later, following a gradual if uneven recovery in economic growth, the
Central Bank has begun to taper (wind down) its Quantitative Easing programme and
is expected to end the programme in the next six months.
(iii)

Discuss the likely impact of the change in monetary policy on:

(a)
(b)
(c)
(d)
(e)

the domestic bond market.

the domestic equity market.
the countrys exchange rate.
domestic economic growth.
domestic inflation.
[25]
[Total 36]

(i)
(ii)

State the factors that should be considered when designing an investment

portfolio for a liability driven investor.

[5]

(a)

List two types of investors who would not normally be considered to

be liability driven.

(b)

Outline why each of the above investors could be considered to be less

constrained than other investors.
[5]

The national government of a large developed country has announced that it is

considering consolidating a large number of public sector pension funds into a single
pension fund. Its aim is to raise governance standards and reduce costs through
increased economies of scale and greater use of passive management where
appropriate. The draft investment guidelines require at least 80% of assets in
domestic equities and bonds to be managed passively in line with a market
capitalisation or customised index. The government has undertaken a consultation
exercise to seek responses from a number of industry bodies.
The chairman of an industry body promoting the interests of active investment
managers has asked the bodys investment actuary to draft a response to the
governments announcement. The purpose of the response is to highlight the benefits
of active management to the wider economy and to investors including public sector
pension funds, who own approximately 20% of the domestic equity and bond
markets.
(iii)

Set out the points the industry bodys actuary should include in his report.
[14]

SA6 A20152

Following the consultation exercise an investment actuary within the governments

policy department has been asked to consider two alternative proposals to the original
proposal that would help achieve governance improvements and greater economies of
scale:

a centralised procurement process for all existing and new manager appointments
setting up a common investment fund for each asset class

The investment actuary has been asked to describe each approach and comment on
the extent to which it achieves the governments objectives relative to the original
proposal.
(iv)

SA6 A20153

Set out the points the governments investment actuary might include in her
report.
[10]
[Total 34]

PLEASE TURN OVER

A new technology company has successfully used modern innovative business

strategies and is now firmly established and growing rapidly. In order to apply a
similar innovative approach to the benefits that it provides for its employees, the
company established a non-pension defined contribution (DC) savings scheme for its
employees five years ago.
The workforce is relatively young with an average age of 25. Given its
entrepreneurial and innovative spirit, the company is investing all savings scheme
contributions into a newly established hedge fund. The hedge fund manager was
given a broad mandate to invest in good long term assets.
The hedge fund manager has invested in a combination of:

equities (quoted and unquoted)

corporate bonds (quoted and unquoted)
property; and
venture capital funds (mostly unquoted).

The trustees of the savings scheme have employed an actuary as an investment

advisor. The hedge fund manager has provided them with detailed statistics and
reports on the performance of the hedge fund. The trustees have asked the actuary to
comment on the performance statistics of the hedge fund.
(i)

Discuss the factors which the actuary should consider in order to comment on
the performance statistics of the hedge fund.
[11]

The trustee board has appointed a new chair who has raised concerns about the
suitability of the hedge fund for the savings scheme.
(ii)

Discuss the factors to consider for the purposes of assessing the hedge funds
suitability for an investment by a DC savings scheme. In your answer you
should consider the following:

the appropriateness of the investment

the key personnel within the hedge fund management team
governance within the hedge fund management team
the quality of the hedge funds business
any other relevant issues.
[19]
[Total 30]

END OF PAPER

SA6 A20154

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
April 2015 examinations

SA6 Investment
Specialist Applications
Introduction
The Examiners Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.
The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.
For numerical questions the Examiners preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.
The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.
F Layton
Chairman of the Board of Examiners
July 2015

Institute and Faculty of Actuaries

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

General comments on Subject SA6
Candidates are reminded to ensure that their answered are sufficiently detailed to demonstrate
understanding, as there were instances where inadequate explanations led to candidates
scoring less well on questions than they might have done. The model solutions are intended
to reflect the level of detail that a high scoring candidate might be able to provide in the
allocated time, to achieve full marks on the paper. Credit is available for valid alternative
solutions, particularly in questions focussed on higher level skills.
Comments on the April 2015 paper
This paper was better answered than recent diets, reflected in an improved pass rate.
Candidates in general demonstrated a good grasp of Core Reading and were able to apply this
knowledge in familiar situations. The examiners continue to feel that candidates ought to be
able to achieve higher scores overall, and a number of candidates struggled to score well in
parts of questions where higher order skills were being assessed or where situations were
unfamiliar and a question needed to be approached from first principles.

Page 2

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

(i)

Quantitative Easing (QE) is a monetary policy used by some central banks to

increase the supply of money. It usually involves both a direct increase in the
money supply and a knock-on effect from the fractional reserve system,
increasing the money supply further. Although it can involve just making
changes to the fractional reserve system, which increases the money supply.
QE is usually implemented by a central bank by first crediting its own account
with money it creates ex nihilo ("out of nothing"). It then purchases financial
assets, for example government bonds, agency debt, mortgage-backed
securities and corporate bonds, from banks and other financial institutions in a
process referred to as open market operations. It can also involve changing the
reserve requirements which through the fractional reserve system would
increase the money supply.

(ii)

Any direct increases in the money supply should put upward pressure on
prices generally
This can be explained using the Quantity Theory of Money
M*V=P*Q
M = the amount of money in an economy
V = the velocity of money the number of times money circulates around the
economy over a specified period
P = the average price level of goods, services and assets
Q = the volume of goods, services and assets produced/transacted
If M increases unless there is an increase in economic activity, there should
be upward pressure on prices.
The main way that QE typically increases the money supply is indirectly
through the fractional reserve system whereby bank assets are bought from
the banks by the central bank in exchange for money which then, due to the
fractional reserve system / money multiplier, results in an increase the money
supply.
The impact of this is typically greatest initially in the asset markets where the
increase in the money supply is experienced both directly and indirectly,
through an increase in the expectations of future money supply increases (as
the QE results in an increase in the money supply over time through the
fractional reserves system).

(iii)

Bond Market
QE typically involves intervention in bond markets by the central bank
increasing bond prices and consequently lowering bond yields. A reduction in
QE is likely to see relatively lower demand for bonds, relatively lower prices
and relatively higher yields.

Page 3

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

QE is typically used to impact the middle to longer end of the yield curve,
which would not be directly impacted by more traditional monetary policy.
Consequently, the impact of tapering is likely to be greatest in the middle to
long end of the yield curve.
The recovery in economic growth may also mean that there is upward pressure
on the central bank base rate and other short term interest rates resulting in
higher short term bond yields.
The impact of inflationary expectations will pay a role. If inflationary
expectations are rising (or deflationary pressures reducing) due to the recovery
in economic growth, this will put upward pressure on longer term bond yields.
The tapering in QE may dampen or possibly negate some of these
expectations, reducing the upward pressure on yields.
The relative impact on the government versus the non-government bond
markets will depend upon the relative degree of tapering in each market
(assuming that QE involved intervention in both the government and the nongovernment bond market).
Equity Market
If the tapering of QE increases bond yields, this will reduce the relative
attractiveness of equities compared to bonds, and also increase the discount
rate at which future earnings are discounted, putting downward pressure on
equity prices.
The impact of inflationary expectations could impact equities. Equities are a
real asset. Higher inflationary expectations (or lower deflationary
expectations) from the economic recovery may mean equity prices rise.
However, higher inflationary expectations (or lower deflationary expectations)
can be negative for equities in the short term, due to any necessity of central
banks to increase interest rates to control it.
Credit also given for similar argument based on economic growth leading to changing
expectations for dividend or earnings growth
The tapering of QE may slow down any growth in the money supply, reducing
the demand for equities.
Higher bond yields should lead to higher commercial interest rates which
should dampen economic activity, decrease corporate profitability and future
dividends, and thus dampen equity prices.
The tapering of QE may have a disproportionate effect on the stock market in
the short term, as QE will likely have had a disproportionate effect on it
earlier.

Page 4

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

Exchange Rate
Initially the exchange rate should rise unless there is similar or greater
tapering of QE in other countries.
Higher interest rates increase the demand for the domestic currency as it
attracts hot money.
Higher exchange rates should decrease the competitiveness of all exports. This
is despite reducing the cost of imported raw materials used in production.
Higher exchange rates should decrease the relative competitiveness and
demand for domestically produced goods and services stimulating domestic
growth in the next few years.
Any increased uncertainty about the economy will likely cause the exchange
rate to fall, or any reduction in uncertainty about the economy will likely cause
the exchange rate to rise. If the market feels more/less confident about the
country's economic growth prospects, then the exchange rate may rise/fall.

Economic Growth
Higher short-term interest rates and bond yields discourage investment
spending by firms and dampen consumer spending. However, there is usually
a lag between increases in interest rates and bond yields and any fall-off in
growth.
Any reduction in capital investment spending by firms reduces employment
levels and therefore incomes. However there is a lag between any reduction in
the planning and building of new production facilities and the full impact on
economic output.
For consumer spending to fall, one or more of the following is needed:

Reduced disposable income from any increase in the cost of servicing

existing debt the effect will be more immediate if borrowing is generally
at floating rather than fixed rates.

Encouraged savings and / or discouraged spending of existing savings

higher interest rates provide more reward for savings. The impact on
consumer confidence will be important (e.g. job security or prospects) on
savings, if consumers feel confident due to the economic recovery, then
the impact on savings may be dampened.

Discouraged personal borrowing higher interest rates make borrowing

more expensive. Again consumer confidence (e.g. job security or
prospects) is an important factor influencing borrowing intentions of
consumers.

Page 5

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

Inflation
The slowdown in the supply of money, all else being equal, should dampen
any inflationary pressures.
Higher exchange rates will decrease the cost of imported goods and services
leading to lower supply side inflation. The impact on the inflation rate will
depend on whether these lower costs can be passed on to consumers. Strong
demand and the pressure of domestic alternatives are a limiting influence.
The use of forward currency contracts will create a longer lag on any impact
on inflation.
Higher real interest rates may mean a decreased quantity of money is
demanded which is met by a decrease in the money supply. This can lead to
lower inflation (demand side).
Demand side inflation can typically have a longer lag than economic growth.
Any rising wage inflation pressures may add to general inflation pressures.
Other
Overseas QE activity may support asset prices despite domestic tapering of
QE.

This was the best answered question on the paper. The first part was relatively well
answered but few candidates achieved close to full marks despite the question being
knowledge based. Candidates tackled the third part reasonably well but only a minority
scored significantly over half marks, which was disappointing.

(i)

The following factors should be considered:

Page 6

whether or not the portfolio has to meet certain known or unknown

cashflows in the future
any minimum hurdles that need to be met such as a minimum rate of
return
whether competitive constraints mean that the portfolio must have regard
to other portfolios of the companys competitors
the risk appetite or objectives of the investor
the performance monitoring process
the sophistication and size of the investor
regulatory and statutory constraints
ethical constraints, and other voluntary constraints
liquidity requirements
minimising costs and tax paid
the investors views on the economic outlook and asset classes

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

(ii)

All investors will have some constraints but the following are examples of
investors with significant assets in excess of their ongoing requirements.
wealthy individuals some individuals have sufficient surplus cash that the
liabilities of financing their future life are small in relation to their personal
assets.
sovereign wealth funds examples include excess funds from natural
resource extraction (e.g. oil) that governments have chosen to save in order to
enhance the quality of living of future generations.
company cash reserves some companies have accrued exceptional profits,
beyond what can reasonably be either invested in the business or used for
acquisition, or returned to investors without tax implications.

(iii)

Market efficiency
Active managers overweight their allocation to investments they consider to
be undervalued, and underweight allocations to investments they consider to
be overvalued. Therefore they contribute to efficient market pricing by
ensuring that market prices of financial assets do not deviate excessively from
fundamental values. Conversely passive managers will maintain allocations
very close to index weights. When some parts of the market are overvalued
(eg a bubble within a sector), passive managers will continue to make
allocations in line with market capitalisation weights.
Liquidity
Active managers improve liquidity as they have higher asset turnover levels
than passive managers. They can further improve liquidity by
opportunistically trading in the opposite direction to large flows, unlike a
passive manager.
Research coverage
Active managers buy significant amounts of research from independent
research organisations and brokers, resulting in a larger supply of such
research.
Active managers also carry out their own fundamental research into
companies and securities.
The above allows a wider range of corporate issuers to be covered by
investment analysts than would otherwise be the case improving primary and
secondary market liquidity due to improved market efficiency. [1] Passive
managers are not significant users of investment research. Corporate
governance
Active managers have regular discussions with company managers to
represent their investors interests. This allows investors to engage with

Page 7

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

corporates on a collective basis, allowing them to represent their interests
more effectively than they would be able to do individually. Passive managers
typically do not carry out this function.
Wealth creation
Active managers generate significant revenues for the national economy, from
both domestic and overseas investors.
If active managers were replaced with passive managers, revenues would fall
and export earnings would fall.
Outperformance potential
Provided that investors select an appropriately skilled manager, investors will
benefit from active management since they gain the potential for higher
returns than if they were to invest in line with an index. Active managers do
this by taking advantage of market inefficiencies and overweight or
underweight mispriced securities relative to a benchmark index.
Investor choice
Active management is a competitive activity with low barriers to entry.
Provided manager fees are transparent an appropriate fee is being charged for
the service provided.

(iv)

Centralised procurement process

The pension funds could reduce investment manager fees by negotiating based
on consolidated assets with each manager.
This would require some coordination (e.g. a pricing committee) but would
not require a new vehicle or funds to be set up, nor any asset transitions.
It will not be feasible to negotiate lower fees for all mandates.
The pension funds assets will be as fragmented as currently, but over time the
funds are likely to migrate assets towards managers with lower fee levels.
A centralised process will also be more efficient in terms of administration and
governance.
Common investment fund
The pension funds could consolidate their holdings on asset class lines (or
some other basis), by transitioning assets into a series of common investment
funds.

Page 8

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

A centralised investment body would then be responsible for manager
structure and selection within the common investment funds.
Each pension fund would then hold units in the common investment funds.
This would allow significant fee reductions to be achieved through
consolidation.
There will be some degree of transition costs where mandates are being
terminated.
Economies of scale achieved are likely to be least under a centralised
procurement process, and highest under the original proposal. A common
investment fund that seeks to broadly maintain the current allocation whilst
achieving some degree of consolidation will be an intermediate approach.
Governance improvements are unlikely under a centralised procurement
approach. A common investment fund is likely to result in improved manager
selection decisions and discipline (if well managed) , and may enable a
superior manager structure to be implemented due to the larger fund size and
the ability to support a larger number of specialist mandates with consistent
investment guidelines . Again it is likely that the original proposal would have
had greater success in improving investment governance.

This question was reasonably well answered. Candidates struggled with the third part and in
particular a number of candidates failed to construct appropriate arguments to support the
industry bodys point of view. Some candidates failed to score as well as they could have in
the final part due to careless reading of the question, which led to them proposing alternative
solutions rather than commenting on the proposals they were asked to discuss.

(i)

Quantitative assessment
Are the returns gross or net of fees? What was the impact of any performance
related fees? Is there sufficient information to allow a transparent assessment
of the fees paid versus returns achieved?
What level of breakdown of the overall return is given? Are performance
figures given by asset category or by individual asset holding?
Are the performance figures outlined in an appropriate and suitable manner to
enable an assessment of relative performance?
Do the performance figures allow an assessment of the level of risk taken?
What measures of investment risk are used? Are they appropriate for the fund?
Is any risk adjusted performance statistics included in the report? Are they
appropriate (appropriate use of beta or standard deviation as the risk
measure)?

Page 9

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

Has an attribution analysis been carried out that enables an assessment of what
were the main positive and negative contributing factors to performance?
Over what time periods are the performance statistics given? Do they also
include historical performance measures over long periods of time?
Has performance varied over time as the funds assets have increased or
decreased?
Is there detailed disclosure of trading costs, third party expenses, and other
manager fees?
Qualitative assessment
How clearly have the figures been communicated in the report? Is the report
user-friendly?
Does the report adhere to Global Investment Performance Standards? Do they
adhere to any other local performance standards?
Does it give a true and fair view of the performance achieved? Are there any
areas of concern? Are there any areas where there is potential bias or other
possible distortions?
Who are the individuals who produced the reports? Are they of an appropriate
character?
The mark-to-market valuations
Has there been any significant inter-period volatility in the valuations?
Have independent valuations been obtained for mark to market assets (eg
derivatives) where there is no single reference price?
The non-mark to market valuations
What methods have been used to value investments where no appropriate
mark to market valuation was possible? Are they appropriate? Are they
consistent with any best practice methods and/or professional guidance?
Is there consistency between the methods used for the non-quoted equities,
bonds and venture capital investments?

Page 10

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

(ii)

Assessing appropriateness of the investment

Does the savings scheme (and/or their advisors including the investment
consultant) consider that financial markets are efficient? If the answer is yes,
then the rational approach might be passive management rather than investing
in a hedge fund. Investing in a hedge fund implicitly assumes a judgment that
markets are not fully efficient.
Assuming that the savings scheme considers that the market is somewhat
inefficient does the investment consultant have a comparative advantage in
picking a high performing hedge fund? To what extent does the consultant
consider that they can do this better than others?
Assessing comparative advantage of the hedge fund
Assuming that investing in a hedge fund has been deemed appropriate for the
savings scheme, the comparative advantage of the hedge fund to be able to
produce superior investment returns needs to be assessed.
People
What is the consultants assessment of the quality of senior people their
experience, track record, motivation/enthusiasm and commitment to the
business? To what extent are the senior people intrinsically or extrinsically
motivated?
To what extent are the key investment decision makers capable of independent
thought? Does the hedge fund have a sufficient number of such individuals?
Do the key investment decisions makers have humility of the ego, or might
they be exposed to ego risk? Are they exposed to letting profits go to their
heads and/or are they exposed to fear when they experience losses?
What is the depth of the hedge funds human capital resources the number of
investment staff involved for each major sector, the dependence on any star
fund manager?
Has there been continuity of staff over recent times? This might be particularly
important where the investment manager has had a successful track record in
the past, and some of the key contributors have moved on.
Process
It could be argued that the hedge fund should have a clear understanding at all
levels of how it expects to achieve good long term returns including the
following:

Internal vs external research

Buy and sell disciplines
Asset allocation approach

Page 11

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

Past performance and attribution analysis can be helpful in evaluating the
consistency of the process, and analysing manager actions.
The decision structure should be capable of being clearly articulated in terms
of the managers ability to make astute and effective decisions, and with clear
articulation of the responsible person for each decision.
The decision process should allow the views of the key people to influence
portfolios
The quality of research and how the hedge fund can translate decisions into
portfolios at best prices will have a significant influence on its performance.
What trading practices are used? Do they have sufficient risk controls? What
type of risk controls are used, VaR etc? Are stop loss policies use, and how?
A characteristic of poor trading would be running losing positions and cutting
profitable positions too early.
Business
What is the quality of systems in the hedge fund? High quality systems can
enable staff to focus on investment decisions, rather than fund administration.
What is the hedge funds policy for growth of business, including restricting
inflows into capacity constrained strategies?
Ability/plans to build capacity where internal resources are the limiting
factor hiring new people, or buying or building new systems
What training/development is available for new staff this is essential for a
business to grow organically.
Is there a good risk management culture?
What retention mechanisms does the hedge fund have? How is key staff
members incentivised to remain with the business?
The best environment for the key investment decision makers is one where
they have the freedom to express skill and flair, where they get appropriate
recognition and reward and where the environment is minimally
dysfunctional.
An efficient policy regarding client contact can be desirable so that a good
balance is struck between having the key investment decisions makers mainly
doing their jobs rather than spending too much time meeting clients
The hedge fund needs to be able to attract and retain key individuals these
individuals are comparable to high performance athletes and need to be
managed accordingly.

Page 12

Subject SA6 (Investment Specialist Applications) April 2015 Examiners Report

The size of the hedge fund can be a consideration if it is too big, it can have
the problems of diseconomies of scale, or if too small can lack the benefits of
economies of scale.
Other factors
What fees will be charged? How do they compare to other hedge funds? Will
the fee structure be based on the 2 and 20 rule 2% and 20% of outperformance?
Brand name does the hedge fund have a good brand name? This may help
take-up of its products.
Administration has the hedge fund got efficient accounting systems and
administrations processes? Or does it outsource this?
Past performance
An investment manager claiming to be capable of high performance will find
it difficult to convince investors if they cannot present some evidence to back
this up, which typically involves demonstrating strong historical performance.
However, past performance, on its own, is not necessarily a good guide to the
future. The factors influencing the past performance need to be determined, to
distinguish between performance achieved through an element of luck and
performance achieved from skill .
Despite past performance having a tenuous link with future performance, it is
still one of the few objective facts available about the hedge fund.
Difficulties
The factors above are difficult to assess as they are likely to vary over time.
Comparative advantages can vary over time also.
A further difficulty of manager research is that teams presenting to researchers
are likely to be well rehearsed both in terms of their message and the
researchers assessment process, so as to maximise the likelihood of a
successful rating.

This was the least well answered question. Many candidates failed to notice that the fund
was a savings plan, rather than a pension plan, which led to the second part of the question
being poorly answered as they misunderstood the investors objectives.

END OF EXAMINERS REPORT

Page 13

INSTITUTE AND FACULTY OF ACTUARIES

2
3
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5

EXAMINATION

6
7
8

13 October 2015 (am)

9
10

Subject SA6 Investment

Specialist Applications

11
12
13
14

Time allowed: Three hours

15
16

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer
booklet.

2.

You have 15 minutes before the start of the examination in which to read the
questions. You are strongly encouraged to use this time for reading only, but notes
may be made. You then have three hours to complete the paper.

3.

You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

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4.

Mark allocations are shown in brackets.

24

5.

Attempt all three questions, beginning your answer to each question on a new page.

25

6.

Candidates should show calculations where this is appropriate.

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22

26
AT THE END OF THE EXAMINATION

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Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

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35

SA6 S2015

Institute and Faculty of Actuaries

An annual pension fund investment conference is being organised and an investment

actuary has been asked to write two articles for the conference magazine which
together will explain how pension funds can invest in infrastructure projects and the
reasons why they should consider this.
(i)

Describe the points that an investment actuary should make in the first article,
under the following headings:
(a)
(b)
(c)

(ii)

What are infrastructure projects?

[5]
What are the investment characteristics of infrastructure projects? [11]
The case for pension funds investing in infrastructure
[5]

Set out the points that an investment actuary should make in the second article
to describe the following:
(a)

the different asset classes that pension funds could hold to invest in
infrastructure projects
[4]

(b)

the different methods of investing in infrastructure assets and the

challenges associated with each method
[13]
[Total 38]

A large property developer has gone bankrupt after completing the development of a
large residential building in the capital city of a small developed country. The
building consists of a number of residential units and these are to be sold at auction.
Bids will be taken for individual units and/or for blocks of multiple units.
An overseas sovereign wealth fund has been built up from excess revenues generated
from natural resource extraction. Its investment mandate is that the funds are to be
reinvested with the aim of enhancing the quality of life for future generations of its
citizens. The funds investment management are considering using some of the
funds assets to purchase some of the units at the auction.
(i)

Discuss, with reference to the investment characteristics, the suitability of this

property investment for the sovereign wealth fund.
[14]

An individual investor is also considering making a bid for one or more units at the
auction. He is not a member of a pension scheme and is looking to make a personal
investment for his own retirement planning (whereby he will use the unit(s) to
generate a rental income).
(ii)

SA6 S20152

Outline reasons why this investment may or may not be suitable for the
individual investor.
[6]
[Total 20]

The state of Woodland (population 10 million) is in the process of becoming

independent from the Republic of Grassland (population 100 million), a major
economy with deep and liquid capital markets. In two years time Woodland will
become an independent nation with its own currency. Monies in Woodland will be
converted into the new currency (Wood Dollars) at a specified rate, and the new
currency will then float freely.
Woodland is in the process of setting up financial institutions including a central
bank, stock exchange and futures exchange and these are expected to become
operational prior to independence. The draft independence agreement requires all
insurers to consult with their Woodland resident policyholders and offer contract
conversion from Grass Dollars (G$) to Wood Dollars (W$) at no cost, if the
policyholder wishes. If policies are not converted the tax treatment will be less
favourable for the policyholder, but the insurers tax position is unchanged.
WoodLife is a life insurance company whose liabilities are split 60% Woodland /
40% rest of Grassland. All of its liabilities are individual annuity policies, with fixed
3% or nil increases. Prior to independence, the assets backing the annuity liabilities
are invested in domestic fixed income and floating rate debt. Interest rate risks are
hedged using fixed income assets and interest rate derivatives.
(i)

Discuss the implications of Woodlands independence for Grasslands debt,

equity, currency and property markets in the short-term.
[12]

(ii)

Discuss the implications of independence for WoodLifes policies in

Woodland in each of the following areas:
(a)

the currency conversion process at independence for both assets and

liabilities
[10]

(b)

interest rate hedging strategy

(c)

investment strategy

END OF PAPER

SA6 S20153

[11]
[9]
[Total 42]

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
September 2015

Subject SA6 Investment

Specialist Applications
Introduction
The Examiners Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.
The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.
For numerical questions the Examiners preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.
The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.
F Layton
Chairman of the Board of Examiners
December 2015

Institute and Faculty of Actuaries

Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

A.

General comments on the aims of this subject and how it is marked

1. The aim of the Investment Specialist Applications subject is to instil in successful
candidates the ability to apply knowledge of the United Kingdom investment environment
and the principles of actuarial practice to the selection and management of investments
appropriate to the needs of investors.
2. Candidates are reminded to ensure that their answers are sufficiently detailed to
demonstrate understanding, as there were instances where inadequate explanations led
to candidates scoring less well on questions than they might have done. The model
solutions are intended to reflect the level of detail that a high scoring candidate might be
able. For many questions there are more marks available than the question requires to
achieve full marks. This reflects that the examiners will give credit for valid alternative
solutions, particularly in questions focussed on higher level skills.

B.

General comments on student performance in this diet of the

examination
This paper was relatively well answered. Candidates in general demonstrated a good grasp
of Core Reading and were able to apply this knowledge in familiar situations. A number of
candidates struggled to score well in parts of questions where higher order skills were being
assessed or where situations were unfamiliar and a question needed to be approached from
first principles.

C.

Comparative pass rates for the past 3 years for this diet of examination
Year
September 2015
April 2015
September 2014
April 2014
September 2013
April 2013

%
46
62
23
28
25
28

Reasons for any significant change in pass rates in current diet to those in the
past:
It should be noted that the number of candidates sitting this exam is very low and so a
reasonably stable pass rate should not be expected.

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Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

Solutions

Q1

(i)

(a)

What are infrastructure projects?

Infrastructure projects are basic facilities, services and installations
needed for the functioning of a community.
Examples include gas pipelines, toll roads, bridges, tunnels, airports,
prisons or hospitals.
Infrastructure projects are generally characterised by their long lives.
Some also have long development times.
They are generally managed and financed on a long-term basis.
Historically it was seen as the role of government to fund and manage
these assets for the good of the population.
Increasingly the assets are owned or managed by the private sector in
ring-fenced structures, with various forms of provision such as joint
ventures, franchises or service agreements.

(b)

What are the investment characteristics of infrastructure projects?

The development period means that there is an initial period of low or
negative cashflows, followed by an extended period where they will
deliver cashflows to their owners. This is often referred to as a
j-curve.
The cashflows often have some degree of inflation linkage.
Cashflows will often exhibit a high degree of stability. This can lead
to low correlations to traditional asset classes.
Often infrastructure assets are natural monopolies or have other unique
characteristics such as location. These give the owners the opportunity
to earn super-normal profits due to low elasticity of demand.
Therefore default risks are low during the operating phase; however
revenues may be subject to price caps by regulators.
During the construction or pre-construction phase of a project, default
risks are higher and cost overruns can be a significant risk leading to
the risk of additional financing being needed or dilution.
Other risks include changing government policy, conflicts of interest
within the government, reliance on government support, legal and
regulatory risks, and wider business / macroeconomic factors that lead
to changing demand.
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Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

Due to the long-term nature of a project, investors normally expect to

be rewarded by means of an illiquidity premium. Similarly most
infrastructure projects are single-purpose therefore this can result in a
premium due to concentration risks.
Typical IRRs can be 1520% during the construction phase (with
higher rates for projects with high levels of risk or uncertainty), and
510% for mature projects with low or highly certain investment costs.
(c)

The case for pension funds investing in infrastructure

Pension funds will find the following aspects attractive:

Low default risks, stable long-term revenue streams, inflation

linkage (some projects), tangible asset, ability to hold long-dated
revenue streams to meet long-dated payments (i.e. low
reinvestment risk), yield, diversification from other asset classes
particularly equity and credit.

They may find the following factors unattractive:

Regulatory uncertainty, illiquidity of investments, construction

phase uncertainty, large investment size, management costs,
complexity of financing structures, governance, specialist expertise
required

In general, larger pension funds are likely to find infrastructure

projects offer attractive investment opportunities, subject to pricing.
(ii)

(a)

Infrastructure asset classes

Infrastructure project can issue equity or debt.
Equity offers greater influence over the underlying project, scope for
higher returns due to capital growth, but higher risk/volatility. Equity
will be a real asset.
Debt offers higher yields, lower risk/volatility, and less exposure to
regulatory risks. Unless the debt is inflation-linked, it will be a fixed
asset. Debt will generally be secured against the project.
In addition, infrastructure exposure can be gained by investing in
assets such as equities issued by infrastructure operators or builders, or
listed funds.

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Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

(b)

Approaches to investing
Listed securities or funds these are listed equities or funds that offer
secondary market liquidity with relatively low costs. These will be
managed in accordance with a published prospectus.
Direct (in-house/segregated account) this is a portfolio of directly
held investments, either public or private. The manager can have
varying levels of discretion, depending on the investors needs and
capabilities.
Unlisted funds many asset managers offer pooled funds that invest
in a diversified portfolio of infrastructure assets. These can be closedended or open-ended. Divestments and investments may be subject to
liquidity restrictions in open ended funds. Funds of funds are also
available. The manager will be responsible for investment decisions,
governance matters, and charge a fee.
Shared platform/club whilst these can be structured as segregated
or pooled accounts, they offer delegation and pooling of governance
but also greater control and lower fees than would apply for a fund.
Challenges
General issues whilst there is increased demand for institutional
funds due to falling bank appetite for holding these assets, institutional
investors often struggle to achieve sufficient scale to build diversified
portfolios. Investors may also struggle with governance issues and
exerting influence on boards. Asset manager fee scales may be
prohibitively high, particularly for infrastructure debt. The long time
horizon means that regulatory risk is potentially greater e.g. due to a
change in tax treatment.
Listed equities or funds issues include the following:

May be difficult to construct a large portfolio using listed assets

Lack of control over underlying investments and transactions
Possible drift of style over time

Direct issues include the following:

Requires sufficient scale to justify set up costs and governance

Without sufficient scale, it may not be possible to construct a
diversified portfolio
Governance requirements may be time intensive
It will take time to build up a portfolio

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Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

Funds issues include the following:

Manager fees can be high, particularly under a fund of funds

approach.
Even where funds are open ended, there can be restricted liquidity
(e.g. gates or anti-dilution levies).
There may also be agency issues, e.g. the manager is incentivised
to gather assets rather than be more selective.

Clubs issues include the following:

Need sufficient interest from committed investors.

Governance arrangements or decision making framework may be
unwieldy depending on the extent of discretions.

Question 1 was generally well answered. The first part was well answered
but few candidates achieved close to full marks despite the question being
knowledge based. The second part was less well answered with only a
minority scoring over half marks, which was disappointing.

Q2

(i)

The investment characteristics of the asset:

Nature of the investment it is a real asset, so likely to produce a real
return over time. The sovereign wealth fund is likely to aim to produce a real
return over time. As well as GDP growth, property returns are influenced by
other factors such as relative demand for property, rental growth relative to
salary or GDP, etc.
Term of the investment it is a long-term investment, producing a flow of
rental income for as long as the property continues to exist. This would make
it a good match to the likely longer term nature of the sovereign wealth fund.
Currency of the investment the rental income is likely to be in local
currency terms so it is unlikely to be a good match for the sovereign wealth
fund unless it is the denominated in the relevant currency. However, assuming
that purchasing power parity holds over the long term, the real nature of the
investment might indirectly hedge any currency risk.
Certainty rents from the property are likely to rise over time, however there
is also a risk of voids. If the property needs to be sold for some reason there is
a risk that the market price is below its fair long term value when the
sovereign wealth fund might want to sell it.
Liquidity / marketability risk the liquidity and marketability of the
investment is likely to be relatively poor, in particular at times of market
distress when it might be more likely that the sovereign wealth fund might

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Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

need or want to dispose of the asset. During times of market distress both
liquidity and marketability might become an issue.
Expertise required the wealth fund will need resources/expertise to manage
the properties e.g. collecting rent, handling problems with the tenant and
organising and carrying out repairs etc. Does the fund have any similar
existing resources or expertise? Or would it need to acquire such expertise?
How many apartments will be purchased? Does the wealth fund have
resources and/or expertise to manage them? Will the number of apartments be
enough to justify hiring any resource necessary to manage them?
Taxes should also be considered, as the sovereign wealth fund is an overseas
investor and may be subject to withholding taxes or be unable to offset taxes
under dual taxation treaties.
Specific characteristics of the properties:
Location of the properties. This will be a key influence on its liquidity and
exposure to voids. Prime properties are typically more liquid and less likely to
experience voids
Residential properties are generally NOT considered to be a good investment
for institutional investors, as the law in most countries is normally considered
to be on the side of the tenant. Additionally the costs of maintain the
investment are considered to be high. The exception is luxury or high-end
residential properties where the tenants are likely to be professionals. If the
apartments are in a prime location it might be more attractive from this
perspective.
Diversification how much diversification do the properties provide? There
is likely to be a concentration risk given that they are all in the same location
and same building. This is less of an issue if the wealth fund is very large and
if it has a very large property portfolio. Does the fund have existing property
assets would this investment add to the diversification among the schemes
assets? Or would it add to concentration risk.
(ii)

There may be circumstances where the investment is attractive. E.g. if the

individual is close to retirement they might consider purchasing apartments
rather than investing their savings in an annuity as they might consider the
annuity to be more expensive and/or likely to produce a significantly lower
income. This might be the case when prices in the property market are quite
depressed say due to a lack of credit availability.
Managing and maintaining the apartments might be attractive to the individual
as a form of employment, either before and/or during their retirement.
However, as the individual ages, they might become less able to directly
manage and maintain the properties or become more reliant on others to do
so.

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Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

If the individual does not have any other form of pension provision or any
other assets, then he/she will be exposed to significant concentration risk.
From a diversification perspective it would be better to own units in different
buildings and locations.
If the property becomes void, which would be more likely if it was not
prime, then the individual might experience detrimental shortfalls income
during retirement
The illiquidity of property may become an inconvenience at a future date if the
investors needs change.
Pooled property investments e.g. REITS/UT may be more suitable.
Question 2 was the best answered question on the paper, with both parts of
the question generally well answered.

Q3

(i)

Currency markets
The introduction of a new currency (W$) will create a meaningful number of
foreign exchange transactions, given the size of Woodland and the
interconnectedness of the two economies.
A forward market in W$ is likely to develop in the run-up to independence,
although it may be volatile and/or one-sided since activity is likely to be
dominated by investment funds or hedging activity.
If the initial exchange rate is set at too high or too low a level then this will
create further volatility.
This volatility should subside once there are two-way trade flows in the
economy and a clearing rate for W$ is achieved.
Equity and debt markets
A fundamental factor is the extent to which obligations under existing
Grassland government bonds are to be assumed by the Woodland government,
and also whether they will be redenominated into W$.
Few existing G$ securities by other issuers are likely to be redenominated into
W$, since only a minority of investors will be Woodland based. However
without a vibrant government debt market it will take time for the Woodland
debt market to achieve critical mass.
Given the relatively small size of Woodland, most issuers are likely to
continue to issue new debt and equity securities in the Grassland markets to
maximise access to liquidity.

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Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

Some debt issuers will want to issue new debt in the Woodland markets, either
to localise Woodland revenues and issuance, or because they want to diversify
their funding base.
Some equity issuers may seek a secondary listing on the Woodland stock
exchange but few large companies are likely to move their primary listing.
If Woodland is slow in developing its own institutions then W$ denominated
debt securities may begin to be issued in the Grassland markets. This could
also happen if it is more tax efficient to issue W$ debt in Grassland rather than
Woodland.
Equities with significant Woodland exposure could be volatile due to investor
uncertainty. There may also be increased volatility in the Grassland equity
markets generally, relative to other major markets.
Interest rates in both Grassland and Woodland could be volatile in the
immediate period after independence. It will take time for a liquid market to
develop in longer dated (over 10 years) W$ interest rates due to lack of
issuance and uncertain investor demand.
Property
Given the physical nature of property, property transactions will need to be
denominated in the currency applying to the location.
This may result in illiquid markets in Woodland around the time of
independence due to uncertainty around the exchange rate.
(ii)

(a)

At the independence date few existing assets in the portfolio are likely
to be automatically converted from G$ to W$. Assets that might be
converted could include some money market instruments and bonds
(most likely Woodland government bonds).
At the independence date the insurers existing liabilities will be
unchanged if no Woodland policyholders choose to convert their
policies.
In practice this is an unlikely scenario given the tax changes. The
conversion rate is likely to depend on both the extent of the tax
differential and policyholders confidence that W$ will not depreciate
following independence.
It is likely that most new Woodland business would be W$
denominated post-independence, as Woodland policyholders would
want to pay W$ denominated premiums and receive W$ benefits.
Where policyholders choose to convert their policies, this will create a
practical difficulty for the insurer since the insurer will be unable to
hedge the future currency mismatch or convert the backing assets into
Page 9

Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

W$ assets until independence. This will result in a mismatch between

assets and liabilities until the asset transition or hedge is completed.
Market capacity for this could be limited if there is an insufficient
supply of suitable assets (government bonds or money market
instruments in particular). Some banks may be willing to make a
market in W$ currency hedges prior to independence, although market
capacity will be limited.
There may also be operational complexities around the conversion
exercise such as late notifications that need to be honoured. This
would increase the extent of uncertainty about conversion rates.
(b)

Where annuities are converted at independence date a G$ guaranteed

payment (with any future increases) will be converted into the
corresponding W$ payment.
This will create a need for W$ interest rate sensitive assets to be held
to match the interest rate sensitivity of the liabilities, with some
sensitivity out to 30 year or longer maturities. Few such assets are
likely to exist at longer maturities until W$ bond markets have grown
in size through new issuance.
This means that the insurer will face particular difficulties in hedging
these risks, and the insurer may be forced to hold shorter duration
assets and tolerate the interest rate mismatch. Banks may issue longer
dated assets (e.g. interest rate swaps) but this will be a capacity
constrained market that is illiquid and expensive to trade until there is a
larger physical / cash market. The insurer may consider overhedging
at shorter maturities to achieve a similar sensitivity to parallel interest
rate movements, but this would create curve risks.
Another possibility is to hold some long-dated G$ interest rate assets
as a proxy against W$ interest rates, and migrate these to W$ interest
rate assets as their duration falls or market liquidity improves.
However hedge effectiveness may be poor, as the correlation between
W$ and G$ interest rates may not be very high.
For new annuities, it is likely that premium bases will reflect these
hedging costs / risks and it may be that W$ guaranteed annuities are
unpopular and alternative products (e.g. unit linked annuities) become
more popular.
Additionally, there will be some unwinding of existing G$ interest rate
hedges or G$ bond sales that needs to be implemented to avoid an
overhedge to G$ interest rates following entering into W$ interest rate
hedges.

(c)

Page 10

The investment strategy will be dominated by the need to invest to

achieve the interest rate sensitivity of the annuity policies.

Subject SA6 (Investment Specialist Applications), September 2015 Examiners Report

However, there will also be a need to achieve a sufficiently high yield

on assets so that the assets can fund the liabilities as they fall due.
Overseas assets can be held but they would need to be hedged back to
W$ or the currency risk tolerated (e.g. due to a relative value view). It
would not be appropriate to hold unhedged overseas assets given the
change of liabilities.
The assets will need to have a similar liquidity profile to the liabilities
to avoid reinvestment risk. This is particularly the case if new business
volumes are low, since there will be less natural liquidity to refine
hedges or fund payments over time.
Whilst it would be desirable to invest in domestic W$ fixed income
and floating rate debt, this will not be possible due to the small market
and difficulty in constructing a diversified portfolio. Therefore there
would need to be greater use of overseas assets in the credit portfolio,
most likely using G$ assets.
If interest rate hedging costs are high, it is possible that a more risky
investment strategy becomes desirable to increase the expected return,
provided the capital implications of doing so are not onerous.
However expected return and capital are likely to be optimised at a
group level rather than at a book level, given the scope for
diversification of risks.
Over time it is likely that the asset allocations for W$ and G$ policies
will diverge given the different liability profiles and the different fixed
income markets.
Question 3 was the least well answered question on the paper. The first part
was reasonably well answered. The second part was the least well answered
part of the paper, with very few candidates scoring more than half marks
despite credit being given for a wide range of relevant comments.

END OF EXAMINERS REPORT

Page 11