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  1. 1. Portable Alpha: What it is and how it can be applied to Insurance Companies' Surplus Portfolios by Pierre Laroche Senior Director Financial Engineering for The 2006 Stochastic Modeling Symposium and Investment Seminar, Toronto, April 4 2006
  2. 2. 1. Desjardins Global Asset Management 2. What is Portable Alpha? 3. PA, Portfolio Volatility and Tracking Error 4. Discussion 5. An Example
  3. 3. <ul><li>Desjardins Global Asset Management (DeGAM) </li></ul><ul><li>DeGAM is Mouvement Desjardins' main portfolio management subsidiary. </li></ul><ul><li>CAD 41 Bn under management: </li></ul><ul><ul><li>CAD 14,5 Bn Fixed Income </li></ul></ul><ul><ul><li>CAD 11,5 Bn Repo </li></ul></ul><ul><ul><li>CAD 9 Bn Multi-Management – Retail </li></ul></ul><ul><ul><li>CAD 5 Bn Funds of Hedge Funds </li></ul></ul><ul><ul><li>CAD 1 Bn Multi-Management – Institutional (Conventional & Quantitative) </li></ul></ul>
  4. 4. Sample: 125 US Defined Benefits Pension Plans Source: JP Morgan Chase, 2005 2. What is Portable Alpha?
  5. 5. 2. What is Portable Alpha? &quot; Portable Alpha refers to the process of separating the alpha from the beta and then applying it to other portfolios &quot; (Kung and Pohlman (2004)) To well understand PA, let's define it as a portfolio enhancement strategy: , r P = excess returns (i.e. returns in excess of the risk-free interest rate) of the enhanced portfolio (E), the base portfolio (B) and the (external) active management mandates (A) that constitute the enhancement sources and where:
  6. 6. 2. What is Portable Alpha? Since actively managed portfolios are usually benched against an index portfolio, we can write: We then have: And since: Then:
  7. 7. <ul><li>Many classical hedge fund strategies carry a mix of alpha and beta. Sometimes, the beta component is quite proheminent. </li></ul><ul><li>For example, most Fixed Income Arbitrage hedge funds use a mix of the three following strategies: </li></ul><ul><ul><li>Buying illiquid securities and/or with more credit risk and selling more liquid securities and/or with less credit risk. </li></ul></ul><ul><ul><li>Riding the interest rate curve (&quot;positive carry&quot; positions). </li></ul></ul><ul><ul><li>Selling interest rate volatility. </li></ul></ul><ul><li>This combination of these three pure beta bets has a circa 0.8 correlation with Tremont's Fixed Income Arbitrage Hedge Fund Index! </li></ul>2. What is Portable Alpha?
  8. 8. 3. PA, Portfolio Volatility and Tracking Error <ul><li>Important issue: Active portfolio management creates t racking error… does that raise the enhanced portfolio's absolute risk (i.e. volatility)? Answer: usually not. </li></ul>Since TE must be non-negative, this last equation requires that: So that if then . We know that: Hence:
  9. 9. 3. PA, Portfolio Volatility and Tracking Error <ul><li>We tested the model over the Jan. 1996 – Dec. 2005 observation period for 269 managers: </li></ul><ul><li>40 TSE Composite 103 SP500 78 MS EAFE 48 MS Emerging markets </li></ul><ul><li>The main results were: </li></ul><ul><ul><li>The median value added is quite small </li></ul></ul><ul><ul><li>The best value added are found for the tougher markets (EAFE and Emerging Markets) </li></ul></ul><ul><ul><li>Most b are less than 1.0 </li></ul></ul><ul><ul><li>The managed portfolios' volatility is equal to that of their benchmark index </li></ul></ul><ul><ul><li>The model is quite well validated by data </li></ul></ul>
  10. 10. 4. Discussion: PMIT <ul><li>The main benefits arising from PMIT's (portable-) alpha and beta separation are: </li></ul><ul><ul><ul><li>The portfolio manager can stick to her strategic asset allocation target (in the pure beta –indexed - portfolio) </li></ul></ul></ul><ul><ul><ul><li>There is no need for modifying the management structure </li></ul></ul></ul><ul><ul><ul><li>It simplifies the portfolio performance attribution </li></ul></ul></ul><ul><ul><ul><li>It allows a simpler risk budgeting </li></ul></ul></ul>
  11. 11. 4. Discussion: Challenges <ul><li>Applying PMIT has several challenges: </li></ul><ul><ul><li>The investment policy may have to be modified, especially regarding the funding decision (financing the pure alpha bets) </li></ul></ul><ul><ul><li>The investment constraints (particularly regarding credit risk limits, leverage and duration) may be harder to define and monitor </li></ul></ul><ul><ul><li>The risk involved may not be well understood (e.g. tracking error) nor measurable with enough precision (e.g. liquidity risk and transparency issues) </li></ul></ul><ul><ul><li>The identification of reliable external managers with above-average alpha investment skills is not an easy task and may be costly </li></ul></ul><ul><ul><li>The best alpha markets are often &quot;difficult&quot; markets </li></ul></ul>
  12. 12. <ul><li>Stochastic Modeling Issues: </li></ul><ul><ul><ul><li>Expected added value, volatility and tracking error are sufficient : no need to take care of the managed portfolios' correlations. Benefit: lower dimension of the correlation matrix/Cholesky Factorization problem. </li></ul></ul></ul><ul><ul><ul><li>Statistical challenges: </li></ul></ul></ul><ul><ul><ul><ul><li>Short observation periods and style drifts (homogegeity of the sampled returns) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Fundamental hypothesis may not be met (estimation and model risks) </li></ul></ul></ul></ul>4. Discussion: Modelling
  13. 13. 4. Discussion: Multi-Management <ul><li>There are many reasons to allocate external active management mandates to at least a dozen of different firms: </li></ul><ul><ul><li>Average value added does not diminish and becomes more stable </li></ul></ul><ul><ul><li>Portfolio volatility diminishes </li></ul></ul><ul><ul><li>Tracking error diminishes a lot </li></ul></ul><ul><ul><li>Information ratio rises substantially </li></ul></ul>
  14. 14. <ul><li>Discussion: Multi-Management </li></ul>
  15. 15. <ul><li>Discussion: Multi-Management </li></ul>
  16. 16. <ul><li>Discussion: Multi-Management </li></ul>
  17. 17. <ul><li>Discussion: Multi-Management </li></ul>
  18. 18. <ul><li>Application to Insurance Companies' Surplus Portfolio </li></ul><ul><li>Important Makeover: </li></ul><ul><ul><ul><li>Active Management </li></ul></ul></ul><ul><ul><ul><li>New Asset Classes (Emerging Markets Bonds, Real Return Bonds, Insurance-Linked Bonds, Commodities, etc.) </li></ul></ul></ul><ul><ul><ul><li>Some Asset Classes Removed (i.e. &quot;transformed&quot;) </li></ul></ul></ul><ul><ul><ul><li>Overlays (fully financed) –vs- lowering Money Market Allocation (… and lowering the duration of the other fixed income allocations) </li></ul></ul></ul><ul><li>Main Challenges: </li></ul><ul><ul><ul><li>Investment Committee's Good Understanding of the Rationale </li></ul></ul></ul><ul><ul><ul><li>Additional Risks and MCCSR Concerns </li></ul></ul></ul>
  19. 19. Question Period