The Art of Risk Management- Strategic Asset Allocation

A NEW DESTINATION FOR
ASSET & LIABILITY MANAGEMENT
10th November 2008
The Art of Risk Management
Strategic Asset Allocation

2
Contents
Risk in an Investment Context 3
Designing an Investment Strategy 7
Monitoring an Investment Strategy 27

3
Introduction
Risk is not always to be avoided ........
“It seems to be a law of
nature, inflexible and
inexorable, that those who
will not risk cannot win."
John Paul Jones
Father of the American Navy

Investment Risk
4
Investment Risk

Liability-Driven Investment
Payments to meet
Liabilities Libor + Investment
Outperformance
Pension
Scheme
Derivative
Overlay
Asset
Portfolio
UK defined benefit pension case
Accessing Assets Efficiently
Portable Alpha
5
Objectives
• 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.
6
Investment Risk
Investment Risk

7
Designing an Investment Strategy

8
Investment Strategy
Top 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’

9
Investment 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

10
Diversification
Diversification: Spreading the Risks and Increasing the Sources of Return
Beta Diversification: Through Investing in Different Markets
Equity
Markets
Company
Earnings
Overall State of
Economy
Bond Markets
Yield Curve
Level and
Shape
Credit Spreads
Return Drivers
of Hedge
Funds
Term spreads,
Volatility,
Liquidity, Credit
Spread, Value
vs. Growth,
Emerging
Market
Return Drivers
of Commodity
Funds
Commodity
Market Trends
and Volatilities
Return Drivers
of Currency
Funds
Currency
Market Trends
and Volatilities
Infrastructure
and Real
Estate
Long term
Economic
Factors
Alpha
Diversification:
Through Investing in
Different Managers
Range of
Different
Markets
Different
Opportunities
to Add Value
Range of
Different
Managers
Different
Managers with
Different Skills

• 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 measurement
11
Investment 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)
12
Designing an Investment Strategy - Benchmark
Functions 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 protection
13
Designing a Benchmark Portfolio

14
12-Month Rolling Returns UK Bond & Equity Mix Portfolio

15
Plot_Grid_SearchPlot_Grid_SearchPlot_Grid_Search
Aug98 Feb01 Sep03 Mar06
-20
-10
0
10
20
40
60
80
End of Month
AnnualReturn(%)
12-Month Rolling Returns UK Bond & Equity Mix Portfolios
Equity100:Bond0
Equity90:Bond10
Equity80:Bond20
Equity70:Bond30
Equity60:Bond40
Equity50:Bond50
Equity40:Bond60
Equity30:Bond70
Equity20:Bond80
Equity10:Bond90
Equity0:Bond100

16
Plot_Grid_SearchPlot_Grid_Search
Jul07 Aug07 Sep07 Oct07 Nov07 Dec07 Jan08 Feb08 Mar08 Apr08 May08 Jun08 Jul08 Aug08 Sep08 Oct08
-30
-25
-20
-15
-10
-5
0
5
10
End of Month
AnnualReturn(%)
12-Month Rolling Returns UK Bond & Equity Mix Portfolios
Equity100:Bond0
Equity90:Bond10
Equity80:Bond20
Equity70:Bond30
Equity60:Bond40
Equity50:Bond50
Equity40:Bond60
Equity30:Bond70
Equity20:Bond80
Equity10:Bond90
Equity0:Bond100

17
Plot_Hist_Rtn
Jul00 May01 Mar02 Jan03 Nov03 Oct04 Aug05 Jun06 Apr07 Mar08
-25
-20
-15
-10
-5
0
5
10
15
20
25
End of Month
AnnualReturn(%)
Annual Return
Option 1
Option 2
Option 3
Compare Performance of Candidate Benchmarks – Traditional Asset Classes Only
Annual Returns

Dec99 Dec00 Dec01 Dec02 Dec03 Dec04 Dec05 Dec06 Dec07
100
150
200
250
300
IndexValue
Index Graph
Date
All Share TR
10 10 10 70 Portfolio
0 0 0 100 Portfolio
18
Designing an Investment Strategy – Benchmark
Performance
Compare 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 0
to 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 funds
15% to 60% .
Generate All Feasible Asset Combinations Possible within Specified Investment
Mandate
• 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 allocations
19
Designing an Investment Strategy – Allocation Ranges
Analysis of Investment Mandates

Equivalent to ......
20

For any particular set of returns either historical or forecast
• Calculate returns available for each feasible portfolio based on historical or
forecast 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 ranges
21
Allocation Ranges

• Review how mandate would have performed historically under different
market 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 ?
22
Back Test Historical Performance of Investment Mandate

23

• During benign regime
• Positive return for all asset
allocations
• Would anticipate manager
would deliver performance
(12-months to date) in the
central box
• Note how size of
performance range
changes
• May ’05: 12% to 17%
• April ’06: 6% to 32%
24
Jun05 Jul06
5
10
15
20
25
30
AnnualReturn(%)
Backtested Performance Range : Fixed 12Mon Allocation
Full date range: 31-Dec-1998 to 31-Oct-2008
12 month return to End of Month
50:50 Bmk
Benchmarks

• During ‘difficult’ times
• Mandate will lead to negative
returns
• Manager has opportunity reduce
losses
• So we can anticipate downside
risk of mandate
– under typical ‘historical’
conditions
However current conditions
2H2008 are not typical!
25
Mar02 Apr03
-30
-25
-20
-15
-10
-5
0
5
10
15
AnnualReturn(%)
50:50 Bmk
Benchmarks

• During recent crisis
– Show manager could protect
some but limited protection
against losses
– Suggests mandate should be
modified to allow more cash to
be held
26
Aug07 Oct08
-30
-20
-10
0
10
20
AnnualReturn(%)
50:50 Bmk
Benchmarks

Monitoring an Investment Strategy
27
Monitoring an Investment Strategy

• Can compare actual performance with feasible performance range for
investment 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 losses
28
Analysis of Performance

29
May04 Jun05 Jul06 Aug07 Oct08
-30
-20
-10
0
10
20
30
AnnualReturn(%)
50:50 Bmk
Nett Pf
Gross Pf
Portfolios & 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 are
related
• 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 risk
30
Analysis of Performance – Tracking Error

31
Black square is actual portfolio
Increasing return and
reduced volatility
Benchmark
Analysis of Performance – Tracking ErrorCompare Performance of Candidate Benchmarks – Traditional Asset Classes
• This shows the fund manager
reducing risk at the expense of
commensurate reduction in
return

32
Summary
Summary

• Risk is a necessary to generate return
• Investment benchmarks and mandates can be designed to provide a balance
between
• Protecting capital
• Generating return to meet objectives
• In line with long term objectives of fund
• Performance must be measured against
– Market Conditions
– Investment Mandate
33
Summary
Key Points

Contacts
Dawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415
dawid@redingtonpartners.com
Robert Gardner | Partner Direct: +44 (0) 207 250 3416
robert.gardner@redingtonpartners.com
Redington Partners LLP
13 -15 Mallow Street London EC1Y 8RD
Telephone: +44 (0) 207 250 3331
www.redingtonpartners.com
THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT
Contacts
Disclaimer
Disclaimer 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 discussion
purposes 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 the
parameters 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 appear
above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed
herein 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 is
indicative 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 executed
transactions 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' actuarial
advisors. 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 that
estimation. 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. This
information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how
such 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 as
accurate.
34

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