Broadly speaking there are four types of asset owners. Each has different purposes and constraints. Additionally each has a different strategy for allocating to alternative investments. This post summarizes the four different types of institutional investors.
- Endowments and Foundations
- Pension Funds
- Sovereign Wealth Funds
- Family Offices
Endowments and Foundations
Endowments are funds established to raise charitable contributions, and support the activities off a non profit organization. University endowments are probably the most common example. They receive donations from alumni, and use the investment income to support university operations. Notably some of the most prestigious colleges also have the largest endowments. Endowments vary widely in size.
Endowments are known for their pioneering approach to alternative investments. Indeed the most robust research backed method for investing in alternatives is called “the endowment model. “ Endowments have light regulations, and exceptionally long time horizons, so they can theoretically invest in anything.
Foundations are similar to endowments, in that they depend on charitable contributions from supporters. Typically foundations are used to fund grants and charitable work. Like endowments, foundations have long time horizons and are able to invest in a wide variety of asset classes.
However, there is an important difference between endowments and foundations: Due to tax regulations, foundations are typically required to distribute a minimum percentage of their assets each year. The need to make regular distributions impacts asset allocation decisions.
Although endowments and foundations serve different purposes, and fall under different tax rules, they often have similar investment policies.
Pension funds are one of the most common types of institutional investor. exist to provide retirement benefits for specific groups. The organization that sets up a pension fund is called a plan sponsor. The plan sponsor might be a corporation, nonprofit, or government entity.
There are four types of pension funds.
National Pension Funds
National Pension Funds provide basic retirement services to citizens of a country. The most famous example is the US Social Security Other economically important examples include South Kora’s National Pension Service, and the Central Provident Fund of Singapore. In some cases, national pension funds operate similarly to sovereign wealth funds. National Pension funds have massive scale and long term time horizons. As a result, they are able to invest in a wide range of alternative investments.
Private Defined Benefit Funds
Private defined benefit funds are another important type of institutional investor. They are set up to provide prespecified benefits to employees of private businesses. Benefits provided are typically based on years of service, salary etc. The plan sponsor is responsible for asset allocation. Private defined benefit funds are long term investors, although not as long term as national pension funds. Private defined benefit funds are able to invest in a wide variety of alternative asset classes.
For a variety of reasons, private defined benefit funds are becoming less common.
Private Defined Contribution Funds
Private defined contribution funds are now more common than defined benefits funds. With defined contribution funds, contributions are deposited into accounts linked to each beneficiary. Upon retirement, the employee gets the amount in the account. The employee is ultimately responsible for managing the plan and bears all the risk. The plan sponsor decides what investments are available for beneficiaries to select. Uneven payout timing of alternative investments, illiquidity, and governemnt regulations typically prevent these funds from offering a wide variety of alternative investments. Additionally, most participants typically fall below the income threshold. Defined contribution funds are typically able to invest in real estate and liquid alternatives though.
Individually Managed Accounts
Individually managed accounts the same as private savings plans. Asset allocation is directed entirely by employee. Examples include Roth IRAs and Traditional IRAs in the united states. These funds enjoy certain tax advantages. However these tax advantages come with additional regulatory scrutiny Consequently there are limits on the alternative asset exposure people can get in individually managed accounts. Private placements are normally not available. One big issue that often comes up is custody. Fortunately, a lot of companies are coming up with custody solutions and are generally working to make it easier for investors to access alternative investments in their individual retirement accounts. Consequently, investors can access precision metals, bitcoin, and certain alternative investments in their individual retirement accounts.
Sovereign Wealth Funds
National governments set up sovereign wealth funds (SWFs) to save and build on the country’s current income, in order to benefit future generations. They are similar to national pension funds in that they are government run, but unlike with national pension funds, they have a broader range of purposes than just providing retirement income.
OVer the past few decades , SWFs have become a major economic force because of their sca. The rise of SWFS has been tied to emerging economies that have large natural resource endowments. Typically SWFs grow when commodities are high. In other cases, such as with China, they are funded by large trade surpluses that give countries with huge amounts of foreign currency.
SWFS have broad investment mandates and long term investment horizons. However, depending on the politics of the particular country, there may be limitations on what they are allowed to invest in. Typically they invest a portion of their funds in alternative assets.
Family offices are organizations dedicated to the management of a pool of capital owned by a wealthy individual or family. Basically they are private wealth advisory firms. Family office is a broad, diverse category. In some cases they are spun off from operating companies, in other cases they are funded by legacy wealth. The goals and investments mandates of family offices vary widely. Sometimes they are focused on maintaining a standard of living. Other times they are focused on providing benefits for future generations, or on philanthropic activities. There are typically differences between the goals and strategies of first, second, and third generation family offices.
Family offices have long time horizons and large scale, so they are often able to invest in a broad range of alternative asset classes.
For more details, check out Alternative Investments: An Allocators Approach