Asset Management and Private Asset Management and Private BankingBanking

Università BicoccaUniversità Bicocca May 2008May 2008

ProgramsPrograms

Equity InvestmentEquity Investment

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Investment Process Investment Process

Asset AllocationAsset Allocation

Alternative investmentAlternative investment

Multymanager / open architectureMultymanager / open architecture

Quantitative Techniques and Risk Quantitative Techniques and Risk ManagementManagement

Investment Process / Asset Investment Process / Asset AllocationAllocation

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ORGANISATION

Risk Management

ASSET ALLOCATION

DIVISION

MUTUAL FUNDS

Forecasting and Strategy

Macro Analysis

Optimisation

Equity

Quantitative analysis

Bond

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Step 1: Identify investor’s characteristics and goalsStep 1: Identify investor’s characteristics and goals

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Investment Process

Step 2: Define the approach (benchmark vs total return) Step 2: Define the approach (benchmark vs total return)

Step 4: Portfolio Construction (Optimisation)Step 4: Portfolio Construction (Optimisation)

Step 5: Choose the financial tool for each asset class (open architecture)Step 5: Choose the financial tool for each asset class (open architecture)

Step 6: Execute TradesStep 6: Execute Trades

Step 3: Forecast risk and return for each asset class Step 3: Forecast risk and return for each asset class

Step 1: investor’ s Step 1: investor’ s characteristicscharacteristics and goals and goals

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Define:

Time Horizon

Risk Tolerance

Set of asset classes (equity, bond, cash, corporate, high yield, hedge fund, private equity)

Approach

Responsibility : Private Banker

benchmark driven (relative return)

risk driven (total return)

Benchmark DrivenBenchmark Driven: investors choose a benchmark according to is risk : investors choose a benchmark according to is risk profile, asset managers takes tactical exposure to maximise expected profile, asset managers takes tactical exposure to maximise expected returns. returns. Esempio:Esempio:

Low RiskLow Risk: 20% Equity 80% Bonds. : 20% Equity 80% Bonds. Medium RiskMedium Risk: 40% Equity 60 Bonds: 40% Equity 60 BondsHigh RiskHigh Risk: 70% Equity 30% Bonds: 70% Equity 30% Bonds

Total ReturnTotal Return: : flexible approach. Asset managers try to maximise expected flexible approach. Asset managers try to maximise expected return given a certain level of risk (Value at Risk). return given a certain level of risk (Value at Risk). EsempioEsempio::

Low RiskLow Risk: VaR 3%: VaR 3%Medium RiskMedium Risk: VaR 5%: VaR 5%High RiskHigh Risk: VaR 10%: VaR 10%

Step 2: Define the approachStep 2: Define the approach

Responsibility : Private Banker / Asset Manager

Asset Allocation vs benchmark

ASSET ALLOCATION OUTPUT

Exposure vs benchmark in terms of:

Asset Class

Country

Currency

Duration

GPF Progress 5 anni Benchmark

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Relative returns in financial markets are predictableRelative returns in financial markets are predictable

Step 3: forecast risk and return

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Responsibility : Asset Allocator, Economist, Strategist

Economic intuition and qualitative judgment Economic intuition and qualitative judgment must be must be supported by empirical evidencesupported by empirical evidence (econometric model, (econometric model, quantitative analysis)quantitative analysis)

Use investment themes that consistently drive returnsUse investment themes that consistently drive returns across global markets and asset classes (long-term across global markets and asset classes (long-term valuation, short-term momentum, fund flows, risk valuation, short-term momentum, fund flows, risk premium, macroeconomic policy)premium, macroeconomic policy)

How do we forecast How do we forecast expected returns?expected returns?

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Forecasting Forecasting ThemeTheme Rationale Rationale

Identify a set of factors, which can be Identify a set of factors, which can be grouped into broad investment themesgrouped into broad investment themes

Fund Flows

Momentum

Risk Premium

Valuation

Macroeconomic Trade – off growth inflationTrade – off growth inflation

Distance between price and fundamentalsDistance between price and fundamentals

Liquidity goes into some asset classes more than othersLiquidity goes into some asset classes more than others

Rapidly appreciating assets often continue to appreciateRapidly appreciating assets often continue to appreciate

Excess Return to invest in the marketExcess Return to invest in the market

Step 3: forecast risk and return

Factors Commonly Used in Forecasting Absolute and Relative Market Factors Commonly Used in Forecasting Absolute and Relative Market ReturnsReturns

Step 3: forecast risk and return

VariableAsset Class

Equity

Bond Policy

Corporate

Currency

Multiple (PE, PB, PCF)

Price Momentum, Earnings Revisions

Corporate cash flow (Buy Backs, Issuance)

Liquidity (M1, M2, Monetary Policy)

Yield Curve

Output Gap

Inflation

Spread over Treasury

Balance Sheet Ratio

Interest Rate Differential

Futures on Interest Rate (Eurodollar, Euribor)

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GrowthGrowth

Step 3: forecast risk and return

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Compare your expectations with market expectationsCompare your expectations with market expectations

InflationInflation

Interest RateInterest Rate

VolatilityVolatility

SentimentSentiment

DCF Implied Earnings DCF Implied Earnings GrowthGrowth

Break Even Inflation (TIPS, O.A.T)Break Even Inflation (TIPS, O.A.T)

Strip of Futures on Interest Rate (Eurodollar, Euribor)Strip of Futures on Interest Rate (Eurodollar, Euribor)

Implied Volatility on Option (VIX)Implied Volatility on Option (VIX)

Risk Premium Risk Premium

Step 4: Portfolio Construction (Optimisation)Step 4: Portfolio Construction (Optimisation)

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Must have a framework to move Must have a framework to move from predictability to from predictability to portfolio constructionportfolio construction

It requires a It requires a solid asset allocation toolsolid asset allocation tool (Mean Variance, (Mean Variance, Black-Litterman) and Black-Litterman) and systematic approach to risk systematic approach to risk managementmanagement

Maximise the Maximise the trade-off between expected gain and volatilitytrade-off between expected gain and volatility or or tracking error, given the client’s tolerance for risk (efficient frontier) tracking error, given the client’s tolerance for risk (efficient frontier) and historical correlation between asset classesand historical correlation between asset classes

Responsibility: Quantitative Research TeamResponsibility: Quantitative Research Team

Portfolio Expected ReturnPortfolio Expected Return = asset class return + alfa = asset class return + alfa generation – costs (management fees and trading costs)generation – costs (management fees and trading costs)

Step 5: Investment ToolsStep 5: Investment Tools

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Identify Optimal Identify Optimal trade off between costs and alfa trade off between costs and alfa generation generation

Investment Tools: Mutual Fund, ETF, Derivatives, Hedge Investment Tools: Mutual Fund, ETF, Derivatives, Hedge Fund.Fund.

The more efficient a market is, the less worthwile it is to pay The more efficient a market is, the less worthwile it is to pay costs for alfa generationcosts for alfa generation (Active Funds). (Active Funds).

Concentrate costs where Alfa generation is highConcentrate costs where Alfa generation is high..

Step 6: Execute TradeStep 6: Execute Trade

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Implement incremental portfolio that reflects current Implement incremental portfolio that reflects current views and alpha strategyviews and alpha strategy

Careful attention to transaction costs, market liquidity, Careful attention to transaction costs, market liquidity, risk constraints and client guidelines.risk constraints and client guidelines.

Responsibility: Fund Manager, TraderResponsibility: Fund Manager, Trader

Asset Allocation and Portfolio ConstructionAsset Allocation and Portfolio Construction

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Portfolio has 3 components:Portfolio has 3 components:

Capital ProtectionCapital Protection Currency, Short Term Bonds, Real YieldsCurrency, Short Term Bonds, Real Yields Financials instrumenst: secuirity, ETFFinancials instrumenst: secuirity, ETF

Core = Market (Beta) ExposureCore = Market (Beta) Exposure Domestic and internationals equities, bonds, corporate, Domestic and internationals equities, bonds, corporate,

high yieldshigh yields Financials instruments: ETF, Passive Funds, Long onlyFinancials instruments: ETF, Passive Funds, Long only

Satellite = Alfa ExposureSatellite = Alfa Exposure Extra return vs marketsExtra return vs markets Financials instruments: Flexible funds, hedge funds, long – Financials instruments: Flexible funds, hedge funds, long –

short equities, multimanager, tactical asset allocationshort equities, multimanager, tactical asset allocation

Asset Allocation and Portfolio ConstructionAsset Allocation and Portfolio Construction

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Strategic asset allocationStrategic asset allocation Medium - Long Term wiews Medium - Long Term wiews Change exposure into the Core Component: equity vs Change exposure into the Core Component: equity vs

Bonds, International equities vs Domestic Equities, Bonds, International equities vs Domestic Equities, Currency exposureCurrency exposure

Change the allocation between Core and SatelliteChange the allocation between Core and Satellite

Tactical asset allocationTactical asset allocation Short term wiewsShort term wiews Change exposure into the Satellite Component: Low Risk vs Change exposure into the Satellite Component: Low Risk vs

High Risk Funds, short term bets on some markets, etc.High Risk Funds, short term bets on some markets, etc.

Dynamic Optimisation between Core and Satellite

Asset Allocation Total ReturnAsset Allocation Total Return

VaR 5 VaR 8 VaR 12

Value at Risk -0.83% -4.03% -6.34%

Capital protection 53% 39% 26%

Euro Currency 20% 9% 5%

Short terms bonds (1 – 3) 33% 30% 21%

Core (beta) 17% 31% 44%

Medium – long Term Bond (5 – 20) 2% 2% 2%

Domestic Equity 7% 14% 20%

International Equity 8% 15% 22%

Satellite (alfa) 30% 30% 30%

Asset Allocation: Capital ProtectionAsset Allocation: Capital Protection

VaR 5 VaR 8 VaR 12

Value at Risk -0.83% -4.03% -6.34%

Capital Protection 53% 39% 26%

Euro Currency 20% 9% 5%

ETF Eonia 5% 2% 1%

FRTR 5 1/2 10/25/08 7% 3% 2%

CCTS 0 06/01/10 4% 2% 1%

CCTS 0 03/01/12 4% 2% 1%

Bond Short Term 1 - 3 33% 30% 21%

Euro Bond Short Term 1-3y 14%    

BTPS 2 1/2 06/15/08 3% 1% 1%

DBR 4 07/04/09 2% 1% 1%

FRTR 4 10/25/09 2% 1% 1%

LYXOR ETF EUROMTS 1-3Y 12% 27% 18%

Asset Allocation: Market Exposure (Beta)Asset Allocation: Market Exposure (Beta)VaR 5 VaR 8 VaR 12

Value at Risk -0.83% -4.03% -6.34%

Core (beta) 17% 31% 44%

Bond 2% 2% 2%

Euro Bond medium Term 3-5y      

Euro Bond Medium Term (5 – 10)      

Euro Bond Long Term (10 – 30)      

Inflation Linked 2% 2% 2%

Euro Corporate Bond      

Bond Global EM      

Bond Global High Yield      

Equity 15% 29% 42%

Equity Italy 1% 3% 5%

Equity Europe 4% 7% 9%

Equity USA      

Equity USA hedged 1% 2% 3%

JANUS WORLD US RISK MG CO-A= 1% 2% 3%

Equity Japan      

Equity Japan hedged 3% 7% 9%

Equity Pacific ex Japan      

Equity Pacific ex Japan hedged 1% 1% 2%

Equity Global EM 2% 3% 5%

Settoriali EU 2% 4% 6%

Asset Allocation: Satellite (Alfa)Asset Allocation: Satellite (Alfa)

VaR 5 VaR 8 VaR 12

Value at Risk -0.83% -4.03% -6.34%

Satellite (alfa) 30% 30% 30%

System 100 10% 10% 10%

Basket Flessibili di Terzi 20% 20% 20%

FORTIS L FUND-CRED SP EMR-CC 2%    

ABN AMRO FDS-ABS RET BD =-A 4% 3%  

CAF-DYNARBITRAGE VR 4 EUR-SC 2% 2%  

JPM INV-HIGH STAT MAR N-A=-A 5% 5% 4%

SCHRODER INT EU ABSOL RT-AAC 2% 4% 4%

MELLON GLOBAL-EV GL ALPHA-A= 3% 3% 4%

AMERICAN EXP WLD-CRY AL+-AE=     2%

FORTIS L FUND-BD CONV WRLD-C 2% 3% 4%

MELLON GLOBAL EV CU OPT-A     2%

Hedge Fund      

Equity InvestmentEquity Investment

Factors driving equity markets returns

Equity markets performance of the last 3 years. What’ s next?

Alfa Generation: TOP Down vs Bottom Up Approach

Quantitative techniques for equity investments

Fundamental analysis and equity valuation

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Market Return + Market Return + Currency ReturnCurrency Return

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Equity Investment

Equity Portfolio Expected ReturnEquity Portfolio Expected Return

Extra-return vs Extra-return vs benchmarkbenchmark

BETABETA ++ ALFAALFA

Market ReturnMarket Return

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Beta: Market Return

+ Dividend (or Earnings) growth+ Dividend (or Earnings) growth

Current Dividend YieldCurrent Dividend Yield

LiquidityLiquidity

+ Change in Multiples (PE, PB, etc)+ Change in Multiples (PE, PB, etc)

Factors changing MultiplesFactors changing Multiples

Earnings CycleEarnings CycleSentimentSentiment

ValuationMarkets look cheap compared to history, fundamentals or other asset class

Metrics: Price MomentumTool: technical analysis

LiquidityLiquidity available for financial investments

Earnings cycleDynamic of earnings growth

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Beta: factors driving market returns

Metrics: Economic Growth, inflation, Yield CurveTool: Macroeconomics analysis

MacroMarkets with best trade off growth / inflation

Metrics: Multiple (PE, PB, DY), Fair Value (DDM, DCF), Relative (B/E Yield)Tool: Fundamental analysis, quantitative metrics

Metrics: EPS Growth, margins, salesTool: Fundamental analysis, quantitative metrics

Metrics: Monetary policy, yield curve, M1 / M2, currency reserves, excess liquidity, corporate cash flow.Tool: Research, Balance Sheet Analysis

MomentumMarkets and currencies have strongrecent outperformance

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2002 – 2006: what was behind the equity market rally?

LiquidityLiquidity

ValuationValuation

All the factors were supportive from the equity market perspectiveAll the factors were supportive from the equity market perspective

Earnings cycleEarnings cycle

MomentumMomentum

Global Profits at record level. Restructuring and margins expansions. Best markets not best economy (Europe vs. USA and China)

StrongStrong

Equity market cheap after 2000 – 2002 collapse Equity market cheap after 2000 – 2002 collapse on multiples and relative to bondson multiples and relative to bonds

Central banks loosening monetary policy after Central banks loosening monetary policy after market collapse and September 11th. Zero market collapse and September 11th. Zero real interest rate, excess global liquidity. real interest rate, excess global liquidity.

Global Growth (3.5% real growth), without Global Growth (3.5% real growth), without inflation (2% CPI Core). inflation (2% CPI Core).

Macro Macro EnvironmentEnvironment

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Active aprroach: philosophy and aims

Extra-return vs Bcmk 200 / 300 bp per year

Disciplined Approach

Rule for portfolio construction and rigorous risk management, Absolute (VaR) and Relative to bcmk (RVaR, Tracking Error)

Minimising Costs Lower trading costs mean higher portfolio returns

Two Phase

Defensive Phase (optimisation)

Immunisation vs a diversified set of risk factors (market, currency, sector, style, size exposure)

Active Phase

Bottom up approach. Two Sources of alfa generation: quantitative model and fundamental analysis

Defensive PhaseDefensive Phase

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Equity portfolio: alfa generation

Evidence shows that Evidence shows that performance vs. benchmark is driven performance vs. benchmark is driven more by bets you are not consciousmore by bets you are not conscious ofof (factor risk exposure, (factor risk exposure, stock you don’t own) than active bets you are aware of. stock you don’t own) than active bets you are aware of.

To maximise expected gains with respect to benchmark and To maximise expected gains with respect to benchmark and subject to a constraint of tracking error, subject to a constraint of tracking error, it is important to it is important to isolate sources of alfa generation.isolate sources of alfa generation.

Optimisation ProcessOptimisation Process

High number of stocksHigh number of stocks (80% market coverage) (80% market coverage)

Market and currency neutralMarket and currency neutral (beta 1) (beta 1)

Sector NeutralSector Neutral

Monitoring ofMonitoring of Style and Size Bias Style and Size Bias

• Multifactor model, covering over 600 stocks

• Transparency (no black box)

• Testing of different sets of variables (fundamental, technical, valuation) for each sector

• Basket of stocks sector neutral

• Backtest over 12 years

Source 2Source 1

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Active PhaseActive PhaseTwo Sources of Alfa GenerationTwo Sources of Alfa Generation

Equity portfolio: alfa generation

Quantitative Model Fundamental Analysis

• Analyst / Fund Managers for most sectors

• Proprietary valuation model (DCF + Break up ROE)

• Qualitative study of the company (sector analysis, company visits, management presentations)

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Investment Process

Three BlocksThree Blocks

1.1. Portfolio Low Tracking ErrorPortfolio Low Tracking Error

2.2. Quantitative Basket (80 – 100 stocks)Quantitative Basket (80 – 100 stocks)

3.3. Fundamental Basket (proprietary valuation model)Fundamental Basket (proprietary valuation model)

NO exposure to Market, Currency, Sector, Style

Alfa concentrated in Stock Picking

Product responsibility = Risk AllocatorProduct responsibility = Risk Allocator

Quantitative AnalystsQuantitative Analysts

Fund Managers /Sector AnalystFund Managers /Sector Analyst

Team

SectorsSectors

Selected Variables Selected Variables

Ranking of Stocks in Each Ranking of Stocks in Each SectorSector

Sector ConstructionSector Construction

Portfolio ConstructionPortfolio Construction

Utilities Banks Energy

Cash Flow P/E Price to Book STM Dividend Yield

EV/EBITDA

1. GDF

2. E.On

3. Enel

4. …

1. UBS

2. BPM

3. Santander

4. …

1. BP

2. ENI

3. Repsol

4. …

GDF, E.On, EnelUBS, BPM, Santander

BP, ENI

SSM

Market

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Construction of Quantitative Model

REFERENCESREFERENCES

Strategic Asset allocation: Portfolio choice for Long Strategic Asset allocation: Portfolio choice for Long Term InvestorsTerm Investors, Oxford University Press, 2002., Oxford University Press, 2002.

The Term Structure of the Risk – Return Trade OffThe Term Structure of the Risk – Return Trade Off . . Financial Analysts Journal, January / February 2005Financial Analysts Journal, January / February 2005

Investment ValuationInvestment Valuation – Damodaran – Wiley Finance - – Damodaran – Wiley Finance - 20042004

Winning the Loser’s GameWinning the Loser’s Game – Charles D. Ellis - 2004 – Charles D. Ellis - 2004