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The Art of Risk Management- Strategic Asset Allocation
 

The Art of Risk Management- Strategic Asset Allocation

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    The Art of Risk Management- Strategic Asset Allocation The Art of Risk Management- Strategic Asset Allocation Presentation Transcript

    • A NEW DESTINATION FORASSET & LIABILITY MANAGEMENT10th November 2008The Art of Risk ManagementStrategic Asset Allocation
    • 2Strategic Asset AllocationContentsRisk in an Investment Context 3Designing an Investment Strategy 7Monitoring an Investment Strategy 27
    • 3Strategic Asset AllocationIntroductionRisk is not always to be avoided ........“It seems to be a law ofnature, inflexible andinexorable, that those whowill not risk cannot win."John Paul JonesFather of the American Navy
    • Strategic Asset AllocationInvestment Risk4Investment Risk
    • Liability-Driven InvestmentPayments to meetLiabilities Libor + InvestmentOutperformancePensionSchemeDerivativeOverlayAssetPortfolioUK defined benefit pension caseAccessing Assets EfficientlyPortable Alpha5Objectives• 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.6Strategic Asset AllocationInvestment RiskInvestment Risk
    • 7Designing an Investment StrategyStrategic Asset AllocationDesigning an Investment Strategy
    • 8Strategic Asset AllocationDesigning an Investment StrategyInvestment StrategyTop 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’
    • 9Strategic Asset AllocationDesigning an Investment StrategyInvestment 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
    • 10DiversificationDiversification: Spreading the Risks and Increasing the Sources of ReturnBeta Diversification: Through Investing in Different MarketsEquityMarketsCompanyEarningsOverall State ofEconomyBond MarketsYield CurveLevel andShapeCredit SpreadsReturn Driversof HedgeFundsTerm spreads,Volatility,Liquidity, CreditSpread, Valuevs. Growth,EmergingMarketReturn Driversof CommodityFundsCommodityMarket Trendsand VolatilitiesReturn Driversof CurrencyFundsCurrencyMarket Trendsand VolatilitiesInfrastructureand RealEstateLong termEconomicFactorsAlphaDiversification:Through Investing inDifferent ManagersRange ofDifferentMarketsDifferentOpportunitiesto Add ValueRange ofDifferentManagersDifferentManagers withDifferent SkillsStrategic Asset AllocationDesigning an Investment Strategy
    • • 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 measurement11Strategic Asset AllocationDesigning an Investment StrategyInvestment 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)12Strategic Asset AllocationDesigning an Investment Strategy - BenchmarkFunctions 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 protection13Strategic Asset AllocationDesigning an Investment Strategy - BenchmarkDesigning a Benchmark Portfolio
    • 14Strategic Asset AllocationDesigning an Investment Strategy - Benchmark12-Month Rolling Returns UK Bond & Equity Mix Portfolio
    • 12-Month Rolling Returns UK Bond & Equity Mix Portfolio15Plot_Grid_SearchPlot_Grid_SearchPlot_Grid_SearchAug98 Feb01 Sep03 Mar06-20-1001020406080End of MonthAnnualReturn(%)12-Month Rolling Returns UK Bond & Equity Mix PortfoliosEquity100:Bond0Equity90:Bond10Equity80:Bond20Equity70:Bond30Equity60:Bond40Equity50:Bond50Equity40:Bond60Equity30:Bond70Equity20:Bond80Equity10:Bond90Equity0:Bond100Strategic Asset AllocationDesigning an Investment Strategy - Benchmark
    • 12-Month Rolling Returns UK Bond & Equity Mix Portfolio16Plot_Grid_SearchPlot_Grid_SearchJul07 Aug07 Sep07 Oct07 Nov07 Dec07 Jan08 Feb08 Mar08 Apr08 May08 Jun08 Jul08 Aug08 Sep08 Oct08-30-25-20-15-10-50510End of MonthAnnualReturn(%)12-Month Rolling Returns UK Bond & Equity Mix PortfoliosEquity100:Bond0Equity90:Bond10Equity80:Bond20Equity70:Bond30Equity60:Bond40Equity50:Bond50Equity40:Bond60Equity30:Bond70Equity20:Bond80Equity10:Bond90Equity0:Bond100Strategic Asset AllocationDesigning an Investment Strategy - Benchmark
    • 17Plot_Hist_RtnJul00 May01 Mar02 Jan03 Nov03 Oct04 Aug05 Jun06 Apr07 Mar08-25-20-15-10-50510152025End of MonthAnnualReturn(%)Annual ReturnOption 1Option 2Option 3Strategic Asset AllocationDesigning an Investment Strategy - BenchmarkCompare Performance of Candidate Benchmarks – Traditional Asset Classes OnlyAnnual Returns
    • Dec99 Dec00 Dec01 Dec02 Dec03 Dec04 Dec05 Dec06 Dec07100150200250300IndexValueIndex GraphDateAll Share TR10 10 10 70 Portfolio15 15 15 55 Portfolio25 25 25 25 Portfolio0 0 0 100 Portfolio18Strategic Asset AllocationDesigning an Investment Strategy – BenchmarkPerformanceCompare 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 0to 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 funds15% to 60% .Generate All Feasible Asset Combinations Possible within Specified InvestmentMandate• 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 allocations19Strategic Asset AllocationDesigning an Investment Strategy – Allocation RangesAnalysis of Investment Mandates
    • Strategic Asset AllocationDesigning an Investment Strategy – Allocation RangesEquivalent to ......20
    • For any particular set of returns either historical or forecast• Calculate returns available for each feasible portfolio based on historical orforecast 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 ranges21Strategic Asset AllocationDesigning an Investment Strategy – Allocation RangesAllocation Ranges
    • • Review how mandate would have performed historically under differentmarket 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 ?22Strategic Asset AllocationDesigning an Investment Strategy – Allocation RangesBack Test Historical Performance of Investment Mandate
    • 23Strategic Asset AllocationDesigning an Investment Strategy – Allocation Ranges
    • • During benign regime• Positive return for all assetallocations• Would anticipate managerwould deliver performance(12-months to date) in thecentral box• Note how size ofperformance rangechanges• May ’05: 12% to 17%• April ’06: 6% to 32%24Strategic Asset AllocationDesigning an Investment Strategy – Allocation RangesJun05 Jul0651015202530AnnualReturn(%)Backtested Performance Range : Fixed 12Mon AllocationFull date range: 31-Dec-1998 to 31-Oct-200812 month return to End of Month50:50 BmkBenchmarks
    • • During ‘difficult’ times• Mandate will lead to negativereturns• Manager has opportunity reducelosses• So we can anticipate downsiderisk of mandate– under typical ‘historical’conditionsHowever current conditions2H2008 are not typical!25Strategic Asset AllocationDesigning an Investment Strategy – Allocation RangesMar02 Apr03-30-25-20-15-10-5051015AnnualReturn(%)Backtested Performance Range : Fixed 12Mon AllocationFull date range: 31-Dec-1998 to 31-Oct-200812 month return to End of Month50:50 BmkBenchmarks
    • • During recent crisis– Show manager could protectsome but limited protectionagainst losses– Suggests mandate should bemodified to allow more cash tobe held26Strategic Asset AllocationDesigning an Investment Strategy – Allocation RangesAug07 Oct08-30-20-1001020AnnualReturn(%)Backtested Performance Range : Fixed 12Mon AllocationFull date range: 31-Dec-1998 to 31-Oct-200812 month return to End of Month50:50 BmkBenchmarks
    • Monitoring an Investment Strategy27Strategic Asset AllocationMonitoring an Investment Strategy
    • • Can compare actual performance with feasible performance range forinvestment 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 losses28Strategic Asset AllocationAnalysis of PerformanceAnalysis of Performance
    • 29Strategic Asset AllocationAnalysis of PerformanceAnalysis of PerformanceMay04 Jun05 Jul06 Aug07 Oct08-30-20-100102030AnnualReturn(%)Backtested Performance Range : Fixed 12Mon AllocationFull date range: 31-Dec-1998 to 31-Oct-200812 month return to End of Month50:50 BmkNett PfGross PfPortfolios & 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 arerelated• 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 risk30Strategic Asset AllocationAnalysis of PerformanceAnalysis of Performance – Tracking Error
    • 31Black square is actual portfolioIncreasing return andreduced volatilityBenchmarkStrategic Asset AllocationAnalysis of PerformanceAnalysis of Performance – Tracking ErrorCompare Performance of Candidate Benchmarks – Traditional Asset Classes• This shows the fund managerreducing risk at the expense ofcommensurate reduction inreturn
    • 32Strategic Asset AllocationSummarySummary
    • • Risk is a necessary to generate return• Investment benchmarks and mandates can be designed to provide a balancebetween• Protecting capital• Generating return to meet objectives• In line with long term objectives of fund• Performance must be measured against– Market Conditions– Investment Mandate33Strategic Asset AllocationSummaryKey Points
    • ContactsDawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415dawid@redingtonpartners.comRobert Gardner | Partner Direct: +44 (0) 207 250 3416robert.gardner@redingtonpartners.comRedington Partners LLP13 -15 Mallow Street London EC1Y 8RDTelephone: +44 (0) 207 250 3331www.redingtonpartners.comTHE DESTINATION FOR ASSET & LIABILITY MANAGEMENTContactsDisclaimerDisclaimer 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 discussionpurposes 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 theparameters 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 appearabove are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressedherein 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 isindicative 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 executedtransactions 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 actuarialadvisors. 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 thatestimation. 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. Thisinformation is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers howsuch 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 asaccurate.34