T h e  P e r u v i a n  M o d e l FIAP International Seminar Melvin Escudero Villavicencio Intendente de AFP Supervision D...
<ul><li>Value Creation Chain in the Private Pension Fund System </li></ul>Investment Management : Portfolios Optimized for...
VALUE FOR THE  AFFILIATE SUPERVISION AND REGULATION BASED ON VALUE CREATION. Continually building credibility and a reputa...
INVESTMENT MANAGEMENT 2  Ample Investment Flexibility: 3  Multifunds : Three clearly differentiated risk profiles. Multifu...
 
Eligible Instruments in Multifund System INVESTMENT MANAGEMENT >60 years >45 and  <60 years >20 and  <45 years Bills Banke...
INVESTMENT MANAGEMENT 4  Disciplined Investment Policies: 5  Benchmarking and Performance Attribution Analysis: Activity B...
PERFORMANCE ATTRIBUTION ANALYSIS
INVESTMENT RISK MANAGEMENT 1  Best Practices in Management Company Structure and Reduction of Conflicts of Interest: 2  Pr...
Board of Directors  Risk Committee  Investment Committee  Investment Unit  Risk Unit  Custody Records and  Accounting Inte...
3  New Pricing System provided by the SBS: INVESTMENT RISK MANAGEMENT <ul><li>Recently Adopted Improvements: </li></ul><ul...
PRICE VECTOR GENERATION Send Final Price Vector (6:00 pm) <ul><li>Price vector Committee: </li></ul><ul><li>5 Representati...
SOVEREIGN CERO CUPON CURVE
FIDUCIARY OBLIGATIONS 1  Pension Funds   Fiduciary Governance : Mitigate conflicts of interest and agency problems. Aligns...
Investments  (Front Office) Risks  (Middle Office) Custody, Record Keeping, and Accounting (Back Office) Pension Fund Fidu...
FIDUCIARY OBLIGATIONS Code of Ethics: Based on international standards and applicable to all personnel involved in the inv...
SUPERVISION OF INVESTMENT AND RISK MANAGEMENT <ul><li>Front Office: Expertise (Specialists) </li></ul><ul><li>Middle Offic...
<ul><li>Start Date:  December 9, 2005 </li></ul><ul><li>Initial low levels of inter-fund movement due to:  </li></ul><ul><...
 
BENEFITS OF THE MULTIFUND SYSTEM <ul><li>Higher expected pension benefits due to compounding effect (1% increase in return...
THE MULTIFUND SYSTEM’S ENVIRONMENT
IMPACT AND ADDED VALUE OF THE MULTIFUND SYSTEM <ul><li>Compliance with international fund management standards </li></ul><...
IMPACTO Y VALOR AGREGADO DE LOS MULTIFONDOS <ul><li>Possibility of lower expected draw on Treasury to cover minimum pensio...
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T h e P e r u v i a n M o d e l

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T h e P e r u v i a n M o d e l

  1. 1. T h e P e r u v i a n M o d e l FIAP International Seminar Melvin Escudero Villavicencio Intendente de AFP Supervision Department of Pension Fund Portfolio Management Santiago de Chile, May, 2006 MULTIFUNDS:
  2. 2. <ul><li>Value Creation Chain in the Private Pension Fund System </li></ul>Investment Management : Portfolios Optimized for Risk-Adjusted Returns Fiduciary Obligations : Supervision based on Investment and Risk Management: SUPERVISION AND REGULATION BASED ON VALUE CREATION. Maximize the Affiliates’ Pension <ul><li>Access to a wide range of instruments </li></ul><ul><li>Disciplined investment policy </li></ul><ul><li>Benchmarking </li></ul><ul><li>Performance Attribution. </li></ul>Investment Risk Management: <ul><li>Market Risk </li></ul><ul><li>Credit Risk </li></ul><ul><li>Operational Risk </li></ul><ul><li>Liquidity Risk </li></ul><ul><li>Risk exposure limits </li></ul><ul><li>Prudent Investor Rule </li></ul><ul><li>Fiduciary governance of Pension Funds </li></ul><ul><li>Best Practices in investment and risk management. </li></ul><ul><li>Monitoring of decision-making and investment policies. </li></ul><ul><li>Auditing of investment management capabilities at the Front-, Middle-, and Back-Office levels </li></ul><ul><li>On-Line access to Fund investments </li></ul><ul><li>Market watch: Vigilance of marketplace transactions. </li></ul>Value Circle Salary (Employer) Pension Fund (AFP) Pension (Insurance Co)
  3. 3. VALUE FOR THE AFFILIATE SUPERVISION AND REGULATION BASED ON VALUE CREATION. Continually building credibility and a reputation for trustworthiness. International standards of regulation and supervision Promotion and development of new investments and markets Knowledge of and experience in local and foreign markets. Highly trained and experienced staff Interaction with major market players Contact with a global network of investment specialists. On-line access to risk and investment information. Exemplarily ethical and professional standards Best investment and risk practices SBS Supervision and Regulation Based on Value Creation Factors which create value: Portfolio Managers Mutual Funds Investment Funds Investment Advisors Benchmarks Houses. Regulators Local Foreign Intermediaries Investment banks Broker dealers Law Firms Rating Agencies Research Companies Foreign Issuers Sovereigns Corporates Mutual Funds Trusts, SPV Local Issuers Sovereign Corporates Inka Bond AFP Investment Policy Front office Middle office Back office Fiduciary Obligations Markets Stock Exchanges Settlement/Clearing Depositories OTC Markets
  4. 4. INVESTMENT MANAGEMENT 2 Ample Investment Flexibility: 3 Multifunds : Three clearly differentiated risk profiles. Multifund System Global Systemic Risk Return Risk Efficient Frontier: Multifund System Efficient Frontier: Previous System Fund 1 Objective: Maximize Risk Adjusted Returns for Each Portfolio Return Risk The major challenge is to find the optimal portfolio given each funds’ objective. Fund Investment Alternatives Risk Earlier System High High   Fund 3 (Growth) Moderate Moderate   Fund 2 (Mixed/Balanced) Low Low   Fund 1 (Conservative) Expected Risk Expected Return    
  5. 6. Eligible Instruments in Multifund System INVESTMENT MANAGEMENT >60 years >45 and <60 years >20 and <45 years Bills Bankers Acceptance Reverse Repos Repos Commercial Paper Bank CDs Time deposits Money Market Accounts Short-term Mutual Funds Money Market Underling can be Exchange Rate, Prices, Rates, or Credit-linked. Swaps Forwards Options Futures Derivatives Mortgage Notes Repos Structured Products Real Estate Funds Fixed Income Investment and Mutual Funds Bank CDs Convertible Bonds Concession-Linked Bonds Revenue Bonds Structured Debt Subordinated Bonds Leasing Bonds Mortgage Backed Securities Central Bank CDs International Organizations (IFC, World Bank) Munis Regional Bonds Agency Issues Sovereign Bonds and Notes Preferred Stock Corporate Bonds Fixed Income Equity Structured Products Equity Investment Funds Equity Mutual Funds ADR / GDR Warrants Common Stock Equity
  6. 7. INVESTMENT MANAGEMENT 4 Disciplined Investment Policies: 5 Benchmarking and Performance Attribution Analysis: Activity Best Practices <ul><li>Analysis of risk-adjusted return performance </li></ul><ul><li>Rebalancing policy based on asset class and investment type. </li></ul>6. Fund monitoring and portfolio rebalancing. <ul><li>Portfolio construction criteria </li></ul><ul><li>Characteristics of trading policy </li></ul><ul><li>Optimization models </li></ul>5. Construction of optimized portfolio <ul><li>Define criteria for selecting between internal and external management </li></ul><ul><li>Investment objective for each instrument type </li></ul><ul><li>Allowable instruments. </li></ul><ul><li>Applicable restrictions and limits. </li></ul><ul><li>Define risk parameters </li></ul>4. Investment policy for each type of instrument. <ul><li>Describe strategic criteria for varying from long-term asset allocation </li></ul><ul><li>Explain the criteria for deciding between active or passive management </li></ul><ul><li>Monitoring procedures and methodologies </li></ul><ul><li>Describe investment styles </li></ul><ul><li>Define internal limits and maximum variation allowed. </li></ul>3. Tactical Asset allocation <ul><li>Eligible asset classes </li></ul><ul><li>Long term investment objectives </li></ul><ul><li>Target long-term diversification </li></ul><ul><li>Benchmark for each asset class </li></ul>2. Strategic Investment Allocation <ul><li>Risk-Adjusted Return Profile. </li></ul><ul><li>Profile of targeted investor </li></ul><ul><li>Risk profile </li></ul>1. Define Fund Objectives <ul><li>Benchmarking allows the managers performance and measurement of risk-adjusted return on a comparative basis. </li></ul><ul><li>Each asset class has its own benchmark </li></ul><ul><li>Each AFP chooses their own benchmark </li></ul><ul><li>Benchmarks can be different between funds, even when they are compared to the same or similar asset classes. </li></ul><ul><li>Benchmarks allow for Performance Analysis </li></ul><ul><li>Performance information will initially be restricted to the SBS and the AFP. Later, the information will be made public. </li></ul>
  7. 8. PERFORMANCE ATTRIBUTION ANALYSIS
  8. 9. INVESTMENT RISK MANAGEMENT 1 Best Practices in Management Company Structure and Reduction of Conflicts of Interest: 2 Professional Risk Management: Responsibility: The AFPs must identify, measure, analyze, monitor, control, and disclose the investment risk of the funds under management, whether or not those risks are quantifiable. The AFPs provide mandatory risk limits with the above mentioned criteria. Minimum returns are established based on Relative VaR. <ul><li>Market Risk: </li></ul><ul><li>Models and systems sufficient to monitor and evaluate all positions. </li></ul><ul><li>Calculate VaR, including sensitivity analysis to key factors, using historical information and stress testing of key risk factors. </li></ul><ul><li>Contingency planning. </li></ul><ul><li>Credit Risk: </li></ul><ul><li>Credit analysis procedures </li></ul><ul><li>Calculate default probability for each instrument and issuer (transition matrix) </li></ul><ul><li>Analyze expected losses. </li></ul><ul><li>Liquidity risk </li></ul><ul><li>Estimate withdrawals. </li></ul><ul><li>Estimate losses from sales of illiquid assets </li></ul><ul><li>Plans for mitigating illiquidity. </li></ul><ul><li>Operational risk: </li></ul><ul><li>Propose and monitor the implementation of internal controls </li></ul><ul><li>Define processes, identify points of failures, and contingency planning. </li></ul><ul><li>Balance Score Card. </li></ul>
  9. 10. Board of Directors Risk Committee Investment Committee Investment Unit Risk Unit Custody Records and Accounting Internal Audit CEO <ul><li>Design and implement the investment policy for each fund </li></ul><ul><li>Optimize the portfolio. </li></ul><ul><li>Manage the portfolio. </li></ul><ul><li>Investment Analysis </li></ul><ul><li>Evaluate investment alternatives. </li></ul><ul><li>Identify, measure, analyze and monitor: </li></ul><ul><li>Market Risk. </li></ul><ul><li>Credit Risk. </li></ul><ul><li>Operational Risk. </li></ul><ul><li>Liquidity Risk. </li></ul><ul><li>Establish investment and risk limits </li></ul><ul><li>Clearing and settlement </li></ul><ul><li>Monitoring of physical movements and registers </li></ul><ul><li>Centralized record keeping. </li></ul><ul><li>Daily Investment Report. </li></ul><ul><li>Fund Accounting. </li></ul>Independent Outside Auditor MANAGEMENT COMPANY STRUCTURE
  10. 11. 3 New Pricing System provided by the SBS: INVESTMENT RISK MANAGEMENT <ul><li>Recently Adopted Improvements: </li></ul><ul><li>Best Practices in Valuation. </li></ul><ul><li>Improved transparency in the valuation of illiquid assets </li></ul><ul><li>Experienced Outside Auditor (international price vendor) </li></ul><ul><li>Price Vector Committee, with outside independent members. </li></ul><ul><li>AFPs can object to specific, individual prices. </li></ul><ul><li>Published zero-coupon sovereign curves. </li></ul><ul><li>Price estimation of illiquid corporate bonds via a credit spread over the sovereign curve makes visible the portfolios volatility. </li></ul><ul><li>The greater visibility of volatility requires the development of an appropriate risk management system. </li></ul><ul><li>Incentives for the development of a derivatives market for interest rate hedging (FRAs and swaps) </li></ul><ul><li>Arbitrage possibilities between local and external bond markets. </li></ul>
  11. 12. PRICE VECTOR GENERATION Send Final Price Vector (6:00 pm) <ul><li>Price vector Committee: </li></ul><ul><li>5 Representatives from the SBS </li></ul><ul><li>2 Independent professionals named by the SBS </li></ul><ul><li>1 Representative of the AFPs </li></ul><ul><li>Functions: Approve and validate the policies, criteria, methodologies and manuals regarding valuation and review objections to pricing. Meets periodically, at minimum, monthly.. </li></ul><ul><li>Valuation Committee: </li></ul><ul><li>4 Representatives of the SBS </li></ul><ul><li>Functions: Approves the final version of the price vector on a daily basis, verifies compliance with the pricing manual, evaluates pricing objections and reports to the Price Vector Committee. </li></ul>Establishes Policies, Criteria, and Methodologies. Reports compliance with the policies, criteria and methodologies and objections received. <ul><li>End Users of Price Vector (AFP) </li></ul><ul><li>Represented on the Price Vector Committee </li></ul><ul><li>Can present objections on a daily basis. </li></ul>Can Object to Preliminary Price Vector (5:00–5:30 pm) Transmits Preliminary Price Vector (5:00 pm) <ul><li>Department of Investment Valuation. </li></ul><ul><li>Technical Team. </li></ul><ul><li>Functions: Produce and distribute the preliminary price vector ( ) and, if there are objections accepted by the Valuation Committee, produce and distribute an updated final price vector ( ). </li></ul>Directs the modification of the preliminary price vector, in the case of a sustained objection (5:00 pm – 6:00 pm)
  12. 13. SOVEREIGN CERO CUPON CURVE
  13. 14. FIDUCIARY OBLIGATIONS 1 Pension Funds Fiduciary Governance : Mitigate conflicts of interest and agency problems. Aligns interests with those of the affiliates Fiduciary Obligation with the Fund Prudent Investor Investment and decision making based in processes with an adequate basis. Specialists professionals in investment and risk management. <ul><li>In the process of investing Fund resources, the AFPs must act : </li></ul><ul><li>With the objective of providing benefits to each Fund’s affiliates; </li></ul><ul><li>With the diligence and competency required of an investment expert; </li></ul><ul><li>With impartiality, care, reserve, discretion, prudence and honesty; </li></ul><ul><li>Maintaining a risk-return balance appropriate with each Fund’s objectives; </li></ul><ul><li>Diversifying the investments in such a way that the portfolio maintains a level of risk reasonable for the Fund’s objectives; and </li></ul><ul><li>Respecting and complying the applicable rules and laws. </li></ul>Responsibilities defined at governing, managerial and operational levels. 2 Prudent Investor Rule:
  14. 15. Investments (Front Office) Risks (Middle Office) Custody, Record Keeping, and Accounting (Back Office) Pension Fund Fiduciary Governance Corporate Governance AFP Board of Directors
  15. 16. FIDUCIARY OBLIGATIONS Code of Ethics: Based on international standards and applicable to all personnel involved in the investment process, it includes Personal Investment Policy, Conflict of Interests, Proper Use of Information, etc. Professional Capacity: The AFP define the minimum requirements for training and experience for investment and risk management personnel to guarantee a sufficiently high level of technical competence. The AFP have indicated a preference for requiring that covered employees pass the CFA Level I exam. Conflicts of Interest: The AFP cannot redistribute gains or losses between funds, within funds, to the management company, or to related third parties. Prohibited Trading Practices: The AFP have drawn up a detailed list of trading practices which will not be used. Some of these practices are Front Running, Cherry Picking, Insider Trading, etc. Marketwatch: Both the AFP and the SBS have marketwatch systems to detect possible trading violations. Evaluation of Trading Costs: The AFP should take an inclusive approach to evaluating investments, including all relevant trading and execution costs, to ensure that they acquire the most competitively priced instruments. 3 Best Practices:
  16. 17. SUPERVISION OF INVESTMENT AND RISK MANAGEMENT <ul><li>Front Office: Expertise (Specialists) </li></ul><ul><li>Middle Office: Appropriate Risk Evaluation </li></ul><ul><li>Back Office: Adequate settlement and clearing, record keeping, and accounting capacity. </li></ul><ul><li>Market Watch </li></ul><ul><li>Prudent Investor Rule </li></ul><ul><li>Best Practices </li></ul><ul><li>Investment Policies </li></ul><ul><li>Performance Analysis </li></ul><ul><li>Risk Limits </li></ul><ul><li>Appropriate Personnel and Resources </li></ul><ul><li>Prevent adverse situations for the affiliate. </li></ul><ul><li>Daily Investment Report including details of all transactions. </li></ul><ul><li>Direct access to depository and custodian accounts </li></ul><ul><li>Validation, checks, and daily audit of the investments and NAV of each fund </li></ul><ul><li>Register of instruments and counterparties. </li></ul><ul><li>Focus on the supervision of processes and the management of investments and risk. </li></ul><ul><li>Specialists with the required know-how to adequately audit investment and risk management. </li></ul><ul><li>Adjust regulation based on market evolution and promote more efficient investment options. </li></ul>4 Modern and flexible regulation and supervision based on best practices: 2 Daily access to detailed risk and investment information: 1 Requirements for the authorization of new asset classes and instruments: 3 Monitoring the diligence of investment management:
  17. 18. <ul><li>Start Date: December 9, 2005 </li></ul><ul><li>Initial low levels of inter-fund movement due to: </li></ul><ul><ul><li>Fund 1: Mandatory transfer for persons over 60. </li></ul></ul><ul><ul><li>Fund 2: Perceived as neutral and well-known </li></ul></ul><ul><ul><li>Fund 3: Perceived as risky. </li></ul></ul><ul><ul><li>Competition caused by the entrance of a new AFP interfered with new system’s publicity campaign </li></ul></ul><ul><ul><li>Electoral uncertainty. </li></ul></ul><ul><ul><li>Wait-and-see attitude. </li></ul></ul>EVOLUTION OF THE MULTIFUND SYSTEM TO DATE <ul><li>Expected higher levels of inter-fund transfers based on return differential between funds. </li></ul><ul><li>Structural limitations on the supply of investment opportunities drives the development of new domestic investment alternatives (private placements, structured products, project finance, etc.) and an evaluation of the external investment limits. Pension funds in the last 6 years have grown at a 27% annual rate. </li></ul>
  18. 20. BENEFITS OF THE MULTIFUND SYSTEM <ul><li>Higher expected pension benefits due to compounding effect (1% increase in returns during 30 years implies around 20% higher expected pension benefit) </li></ul><ul><li>The improved decision-making process and the alignment of the affiliate’s and AFP’s interests towards more efficient investment management, guarantees a transparent process which will generate value for everyone. </li></ul><ul><li>Greater efficiency in the savings-investment cycle of the economy improves the virtuous circle of development and growth, improving the permanent income of affiliates. </li></ul>
  19. 21. THE MULTIFUND SYSTEM’S ENVIRONMENT
  20. 22. IMPACT AND ADDED VALUE OF THE MULTIFUND SYSTEM <ul><li>Compliance with international fund management standards </li></ul><ul><li>Higher volume of assets under management </li></ul><ul><li>Improved competition (3 market segments) </li></ul><ul><li>Economies of scale </li></ul><ul><li>Improved confidence in the Private Pension Fund System. </li></ul><ul><li>Disciplined investment policy </li></ul><ul><li>Front Office </li></ul><ul><li>Middle Office </li></ul><ul><li>Back Office </li></ul><ul><li>Prudent Investor Rule </li></ul><ul><li>Fiduciary governance of funds </li></ul><ul><li>Global Asset Allocation </li></ul><ul><li>Ethical Conduct and professional requirements </li></ul>AFP <ul><li>More financing alternatives. </li></ul><ul><li>New issuers via private placement and new projects. </li></ul><ul><li>Drives the development of new funds, i.e. private equity, venture capital, REITs. </li></ul><ul><li>Drives the development of a local derivatives market. </li></ul><ul><li>Inclusion of small and medium enterprises, both by direct and indirect investment </li></ul><ul><li>Highly competitive financing costs for local issuers. </li></ul><ul><li>Government and Central Bank </li></ul><ul><li>Corporations </li></ul><ul><li>Investment and Speculative Grade issuers </li></ul>Local Issuers <ul><li>Optimized portfolios </li></ul><ul><li>Higher expected risk-adjusted return </li></ul><ul><li>Better diversification across asset classes and instruments </li></ul><ul><li>Necessity for better access to international capital markets to compensate for scarcity of local supply </li></ul><ul><li>Fund 1 (conservative) </li></ul><ul><li>Fund 2 (mixed) </li></ul><ul><li>Fund 3 (growth) </li></ul>Pension Funds <ul><li>Higher account capitalization and expected pension benefit </li></ul><ul><li>Higher level of financial understanding </li></ul><ul><li>Choice based on risk-return profile. </li></ul><ul><li>Age, investment horizon and risk tolerance </li></ul><ul><li>Expected pension benefit. </li></ul><ul><li>Period of association with a particular AFP </li></ul>Affiliates Impact and Value Added Factor Changed by Multifund System
  21. 23. IMPACTO Y VALOR AGREGADO DE LOS MULTIFONDOS <ul><li>Possibility of lower expected draw on Treasury to cover minimum pension shortfalls. </li></ul><ul><li>Strengthening of Pension Reform </li></ul><ul><li>Better pension coverage. </li></ul><ul><li>Pension Policy </li></ul><ul><li>Minimum Pension </li></ul>Government <ul><li>New methods of investment </li></ul><ul><li>Increased number of available asset classes </li></ul><ul><li>Promotes more investment advisory services </li></ul><ul><li>Greater specialization in illiquid and more sophisticated investments </li></ul><ul><li>Improved competition and lower costs. </li></ul><ul><li>Mutual Fund Administrators </li></ul><ul><li>Investment Fund Administrators </li></ul><ul><li>Investment Advisors </li></ul>Portfolio Managers <ul><li>Improved depth and sophistication of local capital markets. </li></ul><ul><li>Drives a virtuous circle of savings and investment. </li></ul><ul><li>Increased contribution towards financing and economic growth. </li></ul><ul><li>Savings </li></ul><ul><li>Investment </li></ul><ul><li>Production </li></ul><ul><li>Employment </li></ul>Economic Growth <ul><li>Greater number of issuers </li></ul><ul><li>Higher transaction volumes </li></ul><ul><li>Greater sophistication </li></ul><ul><li>Greater number of counterparties </li></ul><ul><li>Improved research demand </li></ul><ul><li>Improved competition between counterparties. </li></ul><ul><li>Investment banks </li></ul><ul><li>broker-dealers </li></ul><ul><li>Law Firms </li></ul><ul><li>Rating Agencies </li></ul><ul><li>Research Companies </li></ul>Intermediaries <ul><li>Access to new markets (venture capital, private equity, emerging markets, high yield, real estate, hedge funds) </li></ul><ul><li>Access to derivatives for hedging purposes </li></ul><ul><li>Better diversification across currencies, instruments, regions, and countries </li></ul><ul><li>Sovereign </li></ul><ul><li>Corporates </li></ul><ul><li>Mutual Funds </li></ul>Foreign Issuers Impact and Added Value Factor Changed by Multifund System

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