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STRUCTURING OF THE INTERNATIONAL ASSET ALLOCATION PROCESS
 

STRUCTURING OF THE INTERNATIONAL ASSET ALLOCATION PROCESS

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    STRUCTURING OF THE INTERNATIONAL ASSET ALLOCATION PROCESS STRUCTURING OF THE INTERNATIONAL ASSET ALLOCATION PROCESS Document Transcript

    • 333II1 – International Asset Allocation Structures 1 STRUCTURING OF THE INTERNATIONAL ASSET ALLOCATION PROCESS Global investment industry Participants: • Investors • Investment Managers • Brokers • Consultants and Advisers • Custodians INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 2 Investors Private investors Individuals or small groups of individuals (eg. represented by a family trust). Can have high “net-worth”. In Europe and in the USA there are over 2 million individuals with assets over 1 milion $ (in Asia over 1.5 milion such individuals). INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 3 Institutional investors a) Pension funds Committed to long-term investments Most assets in pension funds are concentrated in the USA, Japan and the UK. Different pension system models in various countries (in continental Europe, for instance, pensions are administered by the government). INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 4 b) Endowments and Foundations Invest contributions made to charitable and educational institutions (eg. Nobel Foundation). c) Insurance Companies Most important – life insurance companies. Collect premiums on life insurance, which are invested until claims are paid. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 5 Investment Managers Very diverse group form the point of view of the role they play (depending on the places where they work). Usually work in the asset management departments in banks or in companies specializing solely in asset management. Charge a fee for their services as well as the share of the generated profits for the client. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 6 Brokers Act as agents for buyers and sellers who charge the commission for their services. Two types of brokers: inter-dealer brokers – work with specialist market makers client (or agency) brokers – deal on behalf of institutional or retail clients INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 7 Consultants and Advisers Independent consultants advise: pension funds, insurance companies, endowments and other foundations. Custodians Keep the securities deposited by the investors. Highly complex procedure due to the national differences in taxation, trading and settlement processes. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 8 Any international asset allocation decision involves thorough and continuous research, management and control. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 9 1. INVESTMENT PHILOSOPHY AND STRATEGY Investment managers should decide on: (a)Passive or active investment strategy (b)Top-Down or Bottom Up portfolio construction (c)Global or specialised asset management (d)Quantitative or subjective investment analysis. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 10 Passive investment strategy Reproduces a market capitalisation- weighted index of all international securities markets. The model for equity funds may be the Morgan Stanley Capital International or the FT international indices. The model for fixed income funds is usually the Salomon Brothers international bond index. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 11 The main assumptions of the passive approach is that (a) a well diversified international portfolio is efficient in a risk-reward framework, and (b)there is zero forecasting ability. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 12 Well-diversified domestic portfolios tend to track the domestic market index but international portfolios do not necessarily track the international market index. International efficiency of world market portfolios has not been empirically proven yet. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 13 A special type of passive strategy is indexation. The objective of indexation is to replicate an existing or a manufactured market index. Large pension funds having already indexed their domestic assets are moving towards indexing their international assets. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 14 One of the problems with structuring international index funds is how to weight each country’s presence to the index. A market capitalisation country weight ignores cross holding of shares. A GDP country weight seems a more sensible approach but it is costly to be implemented and requires portfolio rebalancing each time a new GDP figure is published. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 15 A second problem with structuring international index funds is to decide whether the fund should be hedged for currency risk or not. This is despite of empirical studies having shown that the contribution of currency risk to the total risk of a fund is insignificant. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 16 A final problem with structuring international index funds is to measure its performance after allowing for bonds and cash investments in a variety of currencies. The advantage of a passive strategy is that is less costly than an active one and less demanding in terms of research, management and control. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 17 Active investment strategy Active management aims for higher- return higher risk performance. Managers attempt to time markets and currency switching between them so that to take advantage of low intramarket correlations. Approach requires high-quality management skills and above-average ability at forecasting markets and currencies. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 18 The lack of systematic investment structure and the concentration in a small number of markets and currencies can lead to increased portfolio risk. Forecasting is never easy and entails high commissions and costs. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 19 Top-Down portfolio construction Research department focuses on country and currency analysis. Approach is usually broken into three parts, in the following order: Strategic asset allocation: Decide on the proportion of equity, bonds, cash etc. in the total portfolio. International market exposure: Decide on the proportion of domestic/international market exposure. Tactical asset allocation: select individual securities to satisfy this allocation. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 20 Important questions In strategic asset allocation: 1) Which global benchmarks should be used? 2) What should be the weights? Market capitalization or GDP- related weights? 3) Should the investments be protected against currency risk? If yes – then should there be a full or partial hedging? INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 21 In tactical asset allocation: 1) How often should the individual securities be adjusted (transaction costs!) – monthly, weekly, …..? 2) Which criteria should be used for judging if the assets are over- or underpriced? 3) Should strict rules be applied or are the deviations allowed? 4) How should this process be adjusted given the impact of company related news? INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 22 Bottom-Up portfolio construction Research department specialises by worldwide industry sectors. Approach usually used in international equity portfolios. Start from selecting the best securities (irrespective of nationality or currency origin) within the best performing market sector. Built a portfolio with high-performing shares. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 23 The product of this approach is a portfolio with a market and currency allocation, which is a random result of the securities selected. Manager is more concerned with risk exposure in various sectors than with either market or currency risk exposure. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 24 Global or specialised asset management Global asset management manages all assets of a customer and determines both the asset allocation and the selection of each security for the portfolio. Specialised asset management manages specific investment areas, such as Japanese stocks or gold and gold-linked investments, and leaves the asset allocation for the portfolio to the customer himself. Sensible solution for the small investors only. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 25 Quantitative or subjective investment analysis A quantitative investment process includes: • Econometric or technical forecasting models of markets and currencies; • International asset allocation optimisers; • Dividend-discount models, betas, durations or option valuation models; • Risk management models; and • Performance and risk analysis. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 26 A subjective investment analysis requires high-quality management skills and above-average ability at collecting, analysing and interpreting information on markets and currencies. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 27 2. STRUCTURING THE ASSET ALLOCATION PROCESS. Once the investment philosophy and strategy have been decided, the asset allocation process is structured as follows: (a)Research and analyse the market (b)Find the optimal asset allocation (c)Construct the portfolio (d)Constantly monitor the performance and control the portfolio’s risk. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 28 Research and Market Analysis The major responsibility of the research department is to provide forecasts on currencies, interest rates and national stock indexes. Research and market analysis is performed using large international databases, which contain both price histories and information on economic statistics, markets and individual securities. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 29 Asset Allocation Optimisation and Portfolio Construction To achieve the highest performance for a given level of risk a dynamic optimisation model may used. Optimisation models usually use quadratic programming and involve the development of efficient frontiers. Irrespective of the degree of their sophistication, optimisation models have been developed based on the Markowitz mean-variance framework. More sophisticated ones allow for a number of linear and non-linear constraints. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 30 Performance and Risk Control The final step in the investment process is to monitor the performance and risk of individual portfolios. A way to monitor the effectiveness of the international money manager is to compare the total return of the fund over a specified period and the breakdown of return in terms of capital gains, currency fluctuation and income, with the targets decided on the strategic planning. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 31 Additional information may involve: Performance analysis in terms of asset allocation, market timing and individual stock selection. Provision of evidence of unusual expertise in a particular market. Assessment of attaining the risk diversification objective. Degree of investment strategy’s aggression. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 32 Summary Global investment industry: • Investors Private Institutional (pension funds, endowments & foundations, insurance companies) • Investment Managers • Brokers • Consultants and Advisers • Custodians INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 33 The structure of the international investment process depends on the following decisions: (a)Passive or active investment strategy (b)Top-Down or Bottom Up portfolio construction (c)Global or specialised asset management (d)Quantitative or subjective investment analysis. INTERNATIONAL FINANCIAL INVESTMENT
    • 333II1 – International Asset Allocation Structures 34 Once these decisions have been taken, structuring the asset allocation process involves: 1.Research and market analysis; 2.Asset allocation optimisation; 3.Portfolio construction; and finally 4.Performance and risk control. INTERNATIONAL FINANCIAL INVESTMENT