Asset Allocation and
Alternative Investments
Paul Moody – Head of Investment
Development
Please note


This document is for investment professionals only. The content is not to be
viewed by or used with retail i...
Agenda


  The importance of asset allocation
      The problems with traditional approaches
  Alternative assets
      Co...
Asset Allocation: Harder than it looks!

N. America      Asia Pac     Property     UK Credit    Global FI    Em Mkts      ...
Diversification benefits


   Improve overall risk budget by combining less correlated assets

    Return                 ...
Ontario teachers pension scheme




  Source:Ontario teachers website   Page 5
The problems with traditional asset allocation approaches



Peer group benchmarks results in:
       herd-like mentality ...
Strategic Asset allocation has a major influence on investment performance



                                            ...
Creating optimal portfolios




           Cash                    Emerging
                                    Markets
  ...
So what are the main alternatives?


   Commodities
   Currency and tactical asset allocation overlays
   Infrastructure a...
Commodities


   A consumption asset, not a financial asset
   Access via commodity (index) futures/Exchange Traded Funds
...
Most popular commodity indices: composition variations

                80.0
                       69.4                  ...
Currency and tactical asset allocation overlay strategies

  Currency management
  TAA overlay
      generate returns from...
Infrastructure assets


  Long term capital intensive projects that fulfil major social and/or economic
  needs
  Increasi...
Private Equity


  What is it?
     Venture capital funds: provide start up and development equity capital
     Buyout fun...
Private Equity has divergent performance


      Performance derives from combination of asset class and skill set:
      ...
Hedge Funds


   What is a Hedge Fund?
       Private limited partnership/unregulated pooled investment fund
       admini...
Hedge Funds

  Are all hedge funds the same?
      No agreed definition of what constitutes a hedge fund: very
      heter...
Optimised portfolio including fund manager skill



                                                           Risk and re...
Lessons learned



   Asset allocation is the main driver of investment returns
   Unconstrained asset allocation makes se...
Important notes

Except where stated as otherwise, the source of all information is Morley as at 31 May 2008.
Any future r...
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Diversified Strategy Fund

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Diversified Strategy Fund

  1. 1. Asset Allocation and Alternative Investments Paul Moody – Head of Investment Development
  2. 2. Please note This document is for investment professionals only. The content is not to be viewed by or used with retail investors. Page 1
  3. 3. Agenda The importance of asset allocation The problems with traditional approaches Alternative assets Commodities Currency and tactical asset allocation overlays Infrastructure assets Private Equity Hedge Funds Page 2
  4. 4. Asset Allocation: Harder than it looks! N. America Asia Pac Property UK Credit Global FI Em Mkts Em Mkts Japan Em Mkts Em Mkts 29% 84% 11% 7% 17% 56% 26% 45% 33% 40% Europe Em Mkts UK Credit Property Property Asia Pac Property Em Mkts Asia Pac Asia Pac 25% 66% 10% 7% 10% 44% 19% 35% 30% 37% World Japan O/S Govt O/S Govt UK Credit World World Europe Europe World 25% 47% 8% 5% 9% 34% 15% 29% 22% 10% UK Credit Europe Cash Cash O/S Govt N. America Europe Asia Pac World Global FI 15% 37% 5% 4% 8% 30% 13% 27% 21% 9% UK Equity World Global FI Global FI Cash Japan UK Equity UK Equity Property N. America 14% 25% 3% 2% 3% 23% 13% 22% 18% 8% Global FI UK Equity Europe Em Mkts Em Mkts Europe N. America Property UK Equity Europe 50% 14% 24% -1% -2% -6% 21% 11% 19% 17% 7% Difference in 2007 Property N. America UK Equity Asia Pac Asia Pac UK Equity Japan World N. America UK Equity 12% 23% -6% -4% -14% 21% 11% 10% 7% 5% O/S Govt Property N. America N. America Japan Global FI Global FI UK Credit Japan Cash 9% 14% -12% -12% -19% 13% 9% 9% 7.35% 5% Cash Cash World UK Equity World Property Asia Pac N. America Global FI O/S Govt 6% 4% -13% -13% -20% 11% 7% -7% 7% 4% Japan UK Credit Japan World N. America UK Credit UK Credit Cash Cash UK Credit -9% 0.1% -20% -17% -22% 0.8% 7% 4% 4% 0.4% Asia Pac O/S Govt Em Mkts Europe UK Equity Cash O/S Govt O/S Govt UK Credit Property -9% -1% -31% -18% -23% 3% 5% 4% 0.8% -5% Em Mkts Global FI Asia Pac Japan Europe O/S Govt Cash Global FI O/S Govt Japan -25% -5% -36% -19% -32% 2% 4% -4% 0.7% -10% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Page 3
  5. 5. Diversification benefits Improve overall risk budget by combining less correlated assets Return Return Return + = Risk Risk Risk Asset Class A Asset Class B Combined returns of asset class A + B Our process considers the asset class returns, correlation and consequently the optimal mix Correlation is the degree to which two assets have a tendency to move together ranging from (1) perfect correlation to (-1) perfect inverse correlation Page 4
  6. 6. Ontario teachers pension scheme Source:Ontario teachers website Page 5
  7. 7. The problems with traditional asset allocation approaches Peer group benchmarks results in: herd-like mentality with constrained asset allocation In practice this has resulted in over reliance on equities which: creates problems because of volatility Are rarely diversified across markets inconsistent with regulatory valuation requirements Page 6
  8. 8. Strategic Asset allocation has a major influence on investment performance Primary asset allocation Long-term inputs: return forecasts Risk-return Asset Historic target allocation volatilities Correlation of asset classes Evidence shows asset allocation contributes up to 95% of return variance* * Brinson et al., (1986 & 1991) referenced in J Annaert et al Journal of Banking and finance (2005) 661-680 and Blake et al., (1999) referenced in J Annaert et al Journal of Banking and finance (2005) 661-680 Page 7
  9. 9. Creating optimal portfolios Cash Emerging Markets Efficient Frontier Bootstrap Frontier Absolute Return Emerging Markets Cash Other Assets Absolute Risk Page 8
  10. 10. So what are the main alternatives? Commodities Currency and tactical asset allocation overlays Infrastructure assets Private Equity Hedge Funds Page 9
  11. 11. Commodities A consumption asset, not a financial asset Access via commodity (index) futures/Exchange Traded Funds Choice of index crucial Gorton and Rouwenhorst (2006): commodities have historically provided: equity returns at lower level of risk and with positive skew diversification from equity returns inflation hedge Sources of return spot prices driven by nominal GDP and demand/supply balance backwardation and downward sloping futures curve: positive “roll” Page 10
  12. 12. Most popular commodity indices: composition variations 80.0 69.4 S&P Goldman Sachs Commodity Index Dow Jones - AIG Commodity index 60.0 % of index 40.0 33.0 30.2 18.5 20.0 12.8 10.8 9.1 9.2 4.7 2.4 0.0 Energy Industrial metals Precious metals Agriculture Livestock Source: Thompson Financial constituents snap shot as at end-2007 Page 11
  13. 13. Currency and tactical asset allocation overlay strategies Currency management TAA overlay generate returns from long/short positions across global equity, bond and currency markets exploits inefficiencies in asset prices resulting from: investor sentiment such as excessive optimism or pessimism structural anomalies such as legislation, tax or market habit non profit-maximising market participants Page 12
  14. 14. Infrastructure assets Long term capital intensive projects that fulfil major social and/or economic needs Increasingly PFI financed given public sector spending constraints Economic infrastructure, eg utilities, toll roads Social infrastructure, eg hospitals, prisons As regulated natural monopolies/oligopolies offer bond-plus characteristics: Relatively high and stable longer term inflation linked cash flows High duration Infrastructure assets are ideal for matching long dated liabilities Page 13
  15. 15. Private Equity What is it? Venture capital funds: provide start up and development equity capital Buyout funds: buy into companies cheaply, restructure/change their business model, or buy stake in quoted companies, act as friendly activist… …and sell stake to the market or trade buyer at a sizeable profit What is the objective? generate a return in excess of that from quoted equity Page 14
  16. 16. Private Equity has divergent performance Performance derives from combination of asset class and skill set: Buyout funds outperform venture capital funds* Returns heavily skewed towards top performing funds*: 22.9% top quartile IRR 10.6% mean IRR 0.5% median IRR Evidence of performance persistency* Apparent diversification results from Private Equity values being booked at cost Manager and strategy selection is crucial – increasingly accessed via fund-of- funds * Net Pooled Returns for 279 Private Equity Funds formed 1980 - 2005. Source: Thomson Financial, European Private Equity and Venture Capital Association. 27 July 2006. Page 15
  17. 17. Hedge Funds What is a Hedge Fund? Private limited partnership/unregulated pooled investment fund administered by professional investment managers What do Hedge Funds seek to do? Generate absolute returns, ie positive returns independent of market conditions How? By employing wide range of investment strategies, techniques and instruments Page 16
  18. 18. Hedge Funds Are all hedge funds the same? No agreed definition of what constitutes a hedge fund: very heterogeneous universe Not an asset class: more of a skill set as low correlation between and within strategies Most combine specific strategy with leverage to magnify returns - few are truly hedging market risk as name implies Around 8,000 known hedge funds managing total assets c.$1.5tn – many others escape scrutiny Originally for HNWIs: now institutional investors driving growth Page 17
  19. 19. Optimised portfolio including fund manager skill Risk and return Optimised portfolio including fund 9.0% manager skill EM Equities Alternative 8.0% assets and manager skill UK Equities 7.0% CAPS balanced managed Return 6.0% UK Cash Commodities UK Property 5.0% UK Gilts 4.0% 3.0% 2% 7% 12% 17% 22% 27% 32% Risk Resulting in a highly diversified portfolio targeting equity-like returns for bond-like risk Page 18
  20. 20. Lessons learned Asset allocation is the main driver of investment returns Unconstrained asset allocation makes sense The are an ever increasing number of exotic and alternative asset classes It makes sense to consider the widest array of asset classes Page 19
  21. 21. Important notes Except where stated as otherwise, the source of all information is Morley as at 31 May 2008. Any future returns and opinions expressed are based on our internal forecasts and should not be relied upon as indicating any guarantee of return from an investment with Morley. No part of this document is intended to constitute advice of any nature nor should any part be construed as a recommendation to purchase or sell stocks. Where past performance has been illustrated it is not intended to be a guide to the future. When investing with Morley investors should be aware that the value of an investment and any income from it may go down as well as up. Investors may not get back the original amount invested. Morley is a business name of Morley Fund Management Limited, registered in England No. 1151805. Registered Office: No. 1 Poultry, London EC2R 8EJ. Authorised and regulated in the UK by the Financial Services Authority and a member of the Investment Management Association. Morley is also a business name of Morley Fund Services Limited and Morley Pooled Pensions Limited. All are Aviva companies. Contact us at Morley Fund Management Limited, No. 1 Poultry, London EC2R 8EJ. MFM/MFM/08/xxx Page 20
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