the art of risk management- strategic asset allocation

A NEW DESTINATION FOR

ASSET & LIABILITY MANAGEMENT

10th November 2008

The Art of Risk Management

Strategic Asset Allocation

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Contents

Risk in an Investment Context 3

Designing an Investment Strategy 7

Monitoring an Investment Strategy 27

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Introduction

Risk is not always to be avoided ........

“It seems to be a law of nature, inflexible and inexorable, that those who will not risk cannot win."

John Paul Jones

Father of the American Navy


Investment Risk

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Investment Risk

Liability-Driven Investment

Payments to meet Liabilities Libor + Investment

Outperformance Pension Scheme

Derivative Overlay

Asset Portfolio

UK defined benefit pension case

Accessing Assets Efficiently

Portable Alpha

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Objectives • Generate ‘Libor plus’ returns; • Protect Capital.

• Risk of failing to meet strategic objectives

– Risk of losing capital:

• Downside risk.

– Risk of not meeting investment objective:

• Not achieving target value;

• Not funding a pension scheme.

• However, these risks are opposed:

• Risky investments (e.g. Equity) – generate higher return but may fall in value.

• Safe investments (e.g. Treasury Bills) – Capital is safe but returns are low.

• Balance

– ‘Risk of losing capital’ against ‘risk of generating low returns’;

– Known as the Risk vs. Reward trade-off.

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Investment Risk

Investment Risk

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Designing an Investment Strategy



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Investment Strategy

Top Down Approach

• Portfolio Based

• Consider the value and return of the portfolio as a whole

• Must take into account the interrelationship between assets – Portfolio return is the weighted average of returns of the investment

– Portfolio volatility depends on the correlation between the asset returns

• Diversification – Can reduce portfolio volatility and hence reduce risk

• Using Asset Class Indices

• Weighted by Market Capitalisation

– e.g. FTSE All Share Index, FT Actuaries All Bond Index,....

• Represent overall market return

• shows average return received by all investors in that asset class

• This is called the β or ‘Beta’

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Investment Strategy

• Implementing the Portfolio

• Trackers and ETF – Give pure ‘Beta’ for a very low fee

– Just give the average market return

• Funds and direct investments – Give ‘Beta’ plus α or ‘Alpha’ for a fee (typically several %)

– Paid to outperform market index

– Fund managers selected for skill in particular asset class

» e.g. Bonds, Equity, Hedge Funds, Commodities etc,

• End investor receives – Beta Layer: returns for each asset class in portfolio

– Alpha layer: returns added by fund managers minus fees

• Beta (from the asset allocation) is the largest source of Portfolio Return • Shown by academic and practical studies

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Diversification

Diversification: Spreading the Risks and Increasing the Sources of Return

Beta Diversification: Through Investing in Different Markets

Equity Markets

Company Earnings

Overall State of Economy

Bond Markets

Yield Curve Level and

Shape

Credit Spreads

Return Drivers of Hedge

Funds

Term spreads, Volatility,

Liquidity, Credit Spread, Value

vs. Growth, Emerging Market

Return Drivers of Commodity

Funds

Commodity Market Trends and Volatilities

Return Drivers of Currency

Funds

Currency Market Trends and Volatilities

Infrastructure and Real

Estate

Long term Economic

Factors

Alpha Diversification:

Through Investing in Different Managers

Range of Different Markets

Different Opportunities to Add Value

Range of Different Managers

Different Managers with Different Skills



• Defining an Investment Strategy

• Which asset classes and how much in each

– Asset classes to be used

– Limits on investment

• Benchmark portfolio

– Fixed allocation (e.g. Cash 5%, Bonds 45%, Equity 50%)

• Allocation ranges

– Ranges by asset class (e.g. Cash 0 to 15%, Equity 30-50% ,...)

• Purpose

• Set risk tolerance

– In terms of downside risk

• Manages return expectations

– Levels of return that can be expected

• Provide basis for performance measurement

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Investment Strategy

• Defined as a fixed asset allocation portfolio • Typical example 5% Cash, 45% Bonds, 50% Equities

• Provide long term ‘default’ asset allocation

• Defining ‘acceptable’ levels of risk and return

• May be used as ‘safe harbour’

– when market direction not clear

– during ‘difficult times

– when manager does not have clear view

• Provide basis for performance measurement

• Simple methodology (out performance)

• Widely used (traditional)

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Designing an Investment Strategy - Benchmark

Functions of a Benchmark Portfolio

• Analyse various benchmark architectures

• Different mixes of asset classes (e.g. Cash, Bonds, Equity, Alternatives)

• Different proportions of asset classes

• Using

• Historical back testing

• Statistical Bootstrapping

• Stochastic simulation

• Objective

• To examine behaviour in different market regimes

• Trade-off upside performance vs. downside protection

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Designing a Benchmark Portfolio

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12-Month Rolling Returns UK Bond & Equity Mix Portfolio


15 Plot_Grid_SearchPlot_Grid_SearchPlot_Grid_Search

Aug98 Feb01 Sep03 Mar06

-20

-10

0

10

20

40

60

80

End of Month

An

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Retu

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%)

12-Month Rolling Returns UK Bond & Equity Mix Portfolios

Equity100:Bond0

Equity90:Bond10

Equity80:Bond20

Equity70:Bond30

Equity60:Bond40

Equity50:Bond50

Equity40:Bond60

Equity30:Bond70

Equity20:Bond80

Equity10:Bond90

Equity0:Bond100




16 Plot_Grid_SearchPlot_Grid_Search

Jul07 Aug07 Sep07 Oct07 Nov07 Dec07 Jan08 Feb08 Mar08 Apr08 May08 Jun08 Jul08 Aug08 Sep08 Oct08

-30

-25

-20

-15

-10

-5

0

5

10

End of Month

An

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12-Month Rolling Returns UK Bond & Equity Mix Portfolios

Equity100:Bond0

Equity90:Bond10

Equity80:Bond20

Equity70:Bond30

Equity60:Bond40

Equity50:Bond50

Equity40:Bond60

Equity30:Bond70

Equity20:Bond80

Equity10:Bond90

Equity0:Bond100



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Plot_Hist_Rtn

Jul00 May01 Mar02 Jan03 Nov03 Oct04 Aug05 Jun06 Apr07 Mar08-25

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End of Month

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Annual Return

Option 1

Option 2

Option 3



Compare Performance of Candidate Benchmarks – Traditional Asset Classes Only

Annual Returns

Dec99 Dec00 Dec01 Dec02 Dec03 Dec04 Dec05 Dec06 Dec07

100

150

200

250

300

Ind

ex V

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Index Graph

Date

All Share TR

10 10 10 70 Portfolio



0 0 0 100 Portfolio

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Designing an Investment Strategy – Benchmark

Performance

Compare Performance of Candidate Benchmarks – Traditional Plus Alternatives

– Specified as permissible range of allocation to each asset class

• Example : Cash 10 to 25%, Bonds 10 to 40%, Equity 25 to 50% ,Hedge Funds 0 to 20%, Commodity funds 0 to 10% etc ....

– Specified as permissible ranges of allocation to groups of assets

• Example: Cash + Government bonds: 10% to 50%; Equities plus Hedge funds 15% to 60% .

Generate All Feasible Asset Combinations Possible within Specified Investment Mandate

• Typically consider 100,000 possible combinations of assets

• 100,000 possible asset allocations – all permitted within investment mandate

• Use Monte-Carlo methods → randomly create feasible asset allocations

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Designing an Investment Strategy – Allocation Ranges

Analysis of Investment Mandates



Equivalent to ......

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For any particular set of returns either historical or forecast

• Calculate returns available for each feasible portfolio based on historical or forecast data

• Plot distribution of returns

• Identify

– highest possible return achievable

– 75% percentile

– Mean

– 20% percentile

– Lowest possible return achievable

• Using this technique we can historically back test a set of allocation ranges

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Allocation Ranges

• Review how mandate would have performed historically under different market regimes

• Show most likely performance • Central two quartiles – coloured light blue

• Assess

• Upside potential of mandate – what level of returns could be achieved in good times

• Downside risk – what is risk of under performance or losing capital

• Can manager adjust asset allocation to control risk and/or increase return – Is there enough scope to increase return in good times?

– Is there scope to protect capital in bad times ?

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Back Test Historical Performance of Investment Mandate

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• During benign regime

• Positive return for all asset allocations

• Would anticipate manager would deliver performance (12-months to date) in the central box

• Note how size of performance range changes

• May ’05: 12% to 17%

• April ’06: 6% to 32%

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Jun05 Jul06

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Backtested Performance Range : Fixed 12Mon Allocation

Full date range: 31-Dec-1998 to 31-Oct-2008

12 month return to End of Month

50:50 Bmk

Benchmarks

• During ‘difficult’ times

• Mandate will lead to negative returns

• Manager has opportunity reduce losses

• So we can anticipate downside risk of mandate

– under typical ‘historical’ conditions

However current conditions 2H2008 are not typical!

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Mar02 Apr03

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50:50 Bmk

Benchmarks

• During recent crisis

– Show manager could protect some but limited protection against losses

– Suggests mandate should be modified to allow more cash to be held

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Aug07 Oct08

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50:50 Bmk

Benchmarks

Monitoring an Investment Strategy

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Monitoring an Investment Strategy

• Can compare actual performance with feasible performance range for investment mandate

• Provides fair measure of investment management performance

– Within mandate

– Against market conditions

– Categorise as 1st, 2nd, 3rd or 4th quartile

• Alternatively 1st, 2nd ,3rd or 4th Division performance !

• Can assess if manager is using full range of mandate

– Well: capturing upside opportunities and avoiding downside

– Badly: ignoring upsides or increasing losses

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Analysis of Performance


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May04 Jun05 Jul06 Aug07 Oct08

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50:50 Bmk

Nett Pf

Gross Pf

Portfolios & Benchmarks

• Measure risk relative to benchmark

– Known as Tracking Error (‘Tracking Error Variance’)

• Plot both return and volatility of returns

– Each point represents a ‘feasible portfolio’

– Resultant ‘cloud’ of points shows how return and volatility within mandate are related

• Provides measure of tracking error of actual portfolio

– Hence can distinguish

• ‘Good’ tracking error that increases return or reduces risk

• ‘Bad’ tracking error that decreases return or increases risk

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Analysis of Performance – Tracking Error

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Black square is actual portfolio

Increasing return and reduced volatility

Benchmark



Analysis of Performance – Tracking Error Compare Performance of Candidate Benchmarks – Traditional Asset Classes

• This shows the fund manager reducing risk at the expense of commensurate reduction in return

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Summary

Summary

• Risk is a necessary to generate return

• Investment benchmarks and mandates can be designed to provide a balance between

• Protecting capital

• Generating return to meet objectives

• In line with long term objectives of fund

• Performance must be measured against

– Market Conditions

– Investment Mandate

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Summary

Key Points

Contacts

Dawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415 [email protected] Robert Gardner | Partner Direct: +44 (0) 207 250 3416 [email protected] Redington Partners LLP 13 -15 Mallow Street London EC1Y 8RD Telephone: +44 (0) 207 250 3331

www.redingtonpartners.com THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT

Contacts

Disclaimer

Disclaimer For professional investors only. Not suitable for private customers.

The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence .

Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees' actuarial advisors. Redington Partners will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in that estimation. Additionally, the client recognizes that Redington Partners does not owe any party a duty of care in this respect.

Redington Partners are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate.

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the art of risk management- strategic asset allocation

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