21st century asset allocation

Pensions Conference 2015

24 – 26 June

Hilton, Glasgow

26 June 2015

IFoA Pensions Conference 2015 26 June 2015

21st Century

Asset Allocation

2


It Starts with an Integrated Approach to Investment, Funding and Covenant

3

Asset allocation and investment is only part of the solution. There are more levers to pull.


Seven Steps to Full Funding

4

Asset Allocation

A control cycle process for pension scheme investment management.


A Different Way to Categorise Asset Classes, or, An Alternative to ‘Alternatives’

5

• Private Equity

• Insurance-Linked

Securities

• Infrastructure Equity

• Unlisted Property

• Illiquid Multi Strategy

• Regulatory Capital

Relief

• Direct Mid-market

Lending

• Mezzanine Finance

• Distressed Debt

• Infrastructure Debt

• Commercial Real

Estate Debt

• Long Lease Property

• Ground Rents

• Asset-Backed

Leasing

• Commodity Trade

Finance

• IG Credit

• Leveraged Loans

• Asset-Backed

Securities

• High Yield

• Emerging Market Debt

• Long/Short Credit

• Absolute Return Fixed

Income

• Multi-Class Credit

• Credit Relative Value

• Risk Parity

• Volatility-Controlled

Equities

• Trend Following

Strategies (CTA)

• Alternative Risk

Premia

• Active Long-Only

Equities

• Equity Long-Short

• Diversified Growth

Funds

• Global Macro

Liquid Illiquid

Less Contractual

More Contractual

Illiquid Credit Liquid & Semi-

Liquid Credit

Illiquid Market

Strategies

Liquid Market

Strategies

The dimensions for an asset class in this framework are liquidity and certainty of cashflows.


What’s the Problem? Measuring Funding Ratio Sensitivities Reveals All…

6

60%

70%

80%

90%

100%

110%

120%

130%

140%

150%

Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15

PPF 7800 Aggregate Funding Ratio

Gilts Global Equities UK Linkers Sterling IG Credit Spread

Regression Parameter -1.830 0.294 -0.348 0.278

Standard Error 0.112 0.035 0.082 0.134

t-stat -16.403 8.344 -4.218 2.081

p-value 1.69E-34 5.95E-14 4.38E-05 0.0392

Adjusted R² 87%

Source: PPF, Bloomberg; Redington calculations


(Re)Introducing The Fundamental Law of Active Management

7

Easier choice seems to be to increase breadth, i.e. take more bets!

Information Ratio = Return/Risk

𝐼𝑅 = 𝐼𝐶 × 𝐵𝑅

Information Coefficient (IC) = corr[α,θ]

α = expected (ex ante) return

θ = actual (ex post) return

Breadth (BR) = number of independent positions

Choices: (1) Improve IC (i.e. get better at forecasting returns)

AND/OR (2) increase breadth


Case Study: Let’s Look at a “Typical” Pension Scheme

8

Consider a “typical” UK Pension Scheme with the following characteristics:

- 80% Funded

- Asset Allocation Includes:

• 60% equities

• 25% index-linked gilts

• 15% corporate bonds

- 30% Hedge Ratio (Rates & Inflation)

- Expected Return of LIBOR + 218 bps


Putting the Scheme Through the Risk Lens

9

Rates, equities and inflation dominate risk – as expected.

Expected Return: LIBOR + 218 bps / Var95: 26.5% of liabilities

11.7%1.3% 0.7%

19.9%

8.8%2.2%

2.5% 20.6%

26.5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Equity FX Credit Interest Rate Inflation Interest Rate

Basis

Inflation Basis Diversification Total

Va

R 9

5%

Current VaR 95


Quick Win … Hedge to Funding Ratio

10

Rates and inflation risk moderate with no impact on returns.


11.7%1.3%

0.7%

5.7%

2.5%

2.2%

2.5% 10.8%

15.7%

0%

5%

10%

15%

20%

25%

30%

Equity FX Credit Interest Rate Inflation Interest Rate

Basis


Va

R9

5%

Hedged VaR 95


A Deeper Look at Systematic Liquid Market Strategies

11

• Private Equity


Securities





Relief


Lending


• Distressed Debt


• Commercial Real

Estate Debt


• Ground Rents

• Asset-Backed

Leasing

• Commodity Trade

Finance

• IG Credit

• Leveraged Loans

• Asset-Backed

Securities

• High Yield




Income



Systematic

• Risk Parity

• Volatility-Controlled

Equities

• Trend Following

Strategies (CTAs)

• Alternative Risk

Premia

Discretionary


Equities



Funds

• Global Macro

Liquid Illiquid

Less Contractual

More Contractual


Liquid Credit

Illiquid Market

Strategies

Liquid Market

Strategies


Risk-Controlled Investment Strategies: Volatility-Controlled Equities and Risk Parity

12

Find more on these strategies at:

http://www.slideshare.net/redingtonmedia/redington-teachinriskcontrolledinvestmentstrategiesmarch2013

Risk Allocation in a Simple Risk Parity Strategy

EquitiesBondsCommodities

Volatility-Controlled Equities

- Equity exposure managed through futures to

achieve a certain level of volatility

- Results in a relatively constant allocation of

equity risk through time

- Options can be bought on a volatility-

controlled index much more cheaply due to

minimal vega risk

Risk Parity

- The extension of volatility-controlled equities

to the multi-asset space

- Allocate to asset classes on the basis of risk

rather than capital

- Typically involves moderately leveraging low-

risk asset classes

0%

10%

20%

30%

40%

50%

60%

70%

An

nu

alise

d V

ola

tility

(%

)

Realised Volatility of Standard and Volatility-Controlled Indices

100% Dev 0% EM Index Volatility Control (10% Volatility) Index

http://www.slideshare.net/redingtonmedia/redington-teachinriskcontrolledinvestmentstrategiesmarch2013


Change Equity Exposure to Be Volatility-Controlled with Put Protection

13

Adding volatility-controlled equities significantly reduces risk though brings return down too.


4.8%0.7%

5.4%

2.4%

2.2%

2.5% 7.8%

10.1%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Equity Credit Interest Rate Inflation Interest Rate Basis Inflation Basis Diversification Total

Va

R 9

5%

Vol Control VaR 95


Most of Norway’s Alpha is Driven by Identifiable Risk Factor Exposures

14

- Though taking relatively little active risk in the Fund, this active risk had been dominated by a number of systematic factors.

- This led to the alternative risk premia movement taking hold with various styles identified that could be invested into directly

What was previously thought of as alpha (active return) is now being described as alternative beta.


A Continuum Between Beta and Alpha

15

Alpha

Style Premia

Market Risk Premia (Risk Parity)

Low

C

A

P

A

C

I

T

Y

High Low

High

F

E

E

S


Examples of Style Premia Families Cutting Across Liquid Markets

16

Style premia are intuitive, robust, pervasive and backed by a body of academic research.

•Involves buying assets that recently outperformed peers and selling those that recently underperformed

•For example: go long stocks with highest 3 month return, go short stocks with lowest 3 month return

Momentum

•Consists of buying low-risk, high-quality assets and selling high-risk, low-quality assets

•For example: go long high return-on-equity stocks, go short low return-on-equity stocks

Defensive

•Buying assets that are “cheap” relative to their fundamental value and selling “expensive” assets

•For example: go long lowest price-to-book stocks, go short highest price-to-book stocks

Value

•Implies buying high-yielding assets and selling low-yielding assets

•For example: go long highest yielding currencies, go short lowest yielding currencies

Carry


Diversify Risk Premia … The Final Step

17

A truly diversified portfolio with a similar level of returns but with much less risk.


2.3%

2.3%

2.2%

1.5%0.7%

4.2%

2.5%

2.2%

2.5% 11.9%

8.5%

0%

5%

10%

15%

20%

25%

Equity Commodity Style Premia Trend Credit Interest Rate Inflation Interest Rate

Basis


Va

R 9

5%

Diversified Risk Premia VaR 95


Why Aren’t People Doing This Already? Unconventionality.

18

- Perceived complexity and upfront understanding required

- Novelty of approach: what hedge funds have pursued for a long time only now being brought into pension scheme

management (same was said of LDI when it first appeared though now is commonplace)

- Leverage, Shorting and Derivatives – “the 3 dirty words of finance”

- Straying away from peers

- Higher cost for (long/short) alternative risk premia strategies than for market risk exposures.


What About Illiquids?

19

• Private Equity


Securities





Relief


Lending


• Distressed Debt


• Commercial Real

Estate Debt


• Ground Rents

• Asset-Backed

Leasing

• Commodity Trade

Finance

• IG Credit

• Leveraged Loans

• Asset-Backed

Securities

• High Yield




Income



• Risk Parity

• Trend Following

Strategies (CTA)

• Risk Premia

• Global Macro


• Vol-Controlled Equity


Equities


• Multi-Asset Absolute

Return

Liquid Illiquid

Less Contractual

More Contractual


Liquid Credit

Illiquid Market

Strategies

Liquid Market

Strategies


The Gamut of Opportunities in Illiquid Credit and Illiquid Markets

20


Implementing Illiquid Asset Classes Can be Challenging

21

Calculating the illiquidity premium and de-smoothing returns are as much art as they are science.

- Illiquidity premia can be difficult to measure (e.g. an appropriate liquid market comparator may not always be

available)

- Illiquidity prevents you from changing asset allocation/rebalancing; this has cost which is difficult to quantify though

this figure would need to be netted off from the illiquidity premium

- Return history for newer asset classes are limited at best (e.g. much of the illiquid credit area was previously

dominated by banks)

- In order to get risk measurements consistent with liquid assets, illiquid asset returns need to be de-smoothed:

𝑟𝑡 =1

1 − 𝜙𝑟𝑡∗ −

𝜙

1 − 𝜙𝑟𝑡−1∗ where 𝜙 < 1

Geltner-Ross-Zisler Unsmoothing Process

Note unsmoothing only affects risk estimates, it does not affect expected returns.


A Health Warning on Market Timing

22

- Market timing is notoriously difficult (see chart below)

- Any time spent away from an optimal diversified

portfolio is mathematically punished (as shown by

Samuelson)

- That said, where there is skill in this pursuit, this

needs to be evidenced both qualitatively and

quantitatively to have conviction

Source: Deutsche Bank


Benchmarking and Return Decompositions

23

0

50

100

150

200

250

300

350

400

450

Static Allocation Asset Allocation Proxy Fund

3.68%

4.31%

2.09% 10.08%

0%

2%

4%

6%

8%

10%

Static

Allocation

Allocation

Between

Asset Classes

Allocation

Within Asset

Classes

Fund

Exc

ess R

etu

rn

Decomposing By Return

0.37

0.44

0.19 1.00

0

0.2

0.4

0.6

0.8

1

Static

Allocation

Allocation

Between

Asset Classes

Allocation

Within Asset

Classes

Fund

Sh

arp

e R

ati

o

Decomposing By Sharpe Ratio

Decomposing a fund’s returns helps to explain the

evidence of skill (or lack thereof!)

Allocation

between

asset

classes

Allocation

within

asset

classes


Conclusions

24

- Asset allocation is one part of investment strategy. Investment strategy itself is part of pension scheme management

alongside covenant and funding strategy.

- Pension scheme investment strategy is still heavily dominated by four risk factors: (long) equities, (short) interest rates,

(short) inflation and (long) credit which represent a narrow set of bets.

- Greater risk balance of these factors and also the introduction of alternative risk factors is likely to lead to a more

efficient investment strategy (either a similar level of return for a lower level of risk or a higher level of return for the

same level of risk).

- Unconventionality is one of they key constraints preventing wider adoption. As with LDI, it will take time for this to filter

through.

- There is a wide array of illiquid asset classes pension schemes are starting to look at. A framework needs to be in

place to assess illiquidity premia and the requisite compensation for illiquidity. Returns need to be de-smoothed to

integrate with liquid asset classes.

- Market timing (i.e. tactical asset allocation) is difficult though where there is ability to add value through this pursuit,

there needs to be evidence of skill. Decomposing fund returns is one way of identifying this.


References

25

Ang, A., W. Goetzmann and S. Schaefer (2009), “Evaluation of Active Management of the Norwegian GPFG”,

Norway: Ministry of Finance

Grinold, R.C. (1989), “The Fundamental Law of Active Management”, Journal of Portfolio Management, 15,

3, pp. 30-37

Samuelson, P.A. (1990), “Asset allocation could be dangerous to your health”, Journal of Portfolio

Management, 16, 3, pp. 5-8

IFoA Pensions Conference 2015 26 June 2015 26

Disclaimer

For professional investors only. Not suitable for privatecustomers.

The information herein was obtained from various sources.We do not guarantee every aspect of its accuracy. Theinformation is for your private information and is fordiscussion purposes only. A variety of market factors andassumptions may affect this analysis, and this analysis doesnot reflect all possible loss scenarios. There is no certaintythat the parameters and assumptions used in this analysiscan be duplicated with actual trades. Any historicalexchange rates, interest rates or other reference rates orprices which appear above are not necessarily indicative offuture exchange rates, interest rates, or other reference

rates or prices. Neither the information, recommendationsor opinions expressed herein constitutes an offer to buy orsell any securities, futures, options, or investment productson your behalf. Unless otherwise stated, any pricinginformation in this document is indicative only, is subject tochange and is not an offer to transact. Where relevant, theprice quoted is exclusive of tax and delivery costs. Anyreference to the terms of executed transactions should betreated as preliminary and subject to further due diligence.

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Contacts

Aniket Das FIA FIAA CFA Senior Vice PresidentDirect Line: 020 3326 [email protected]

21st century asset allocation

Economy & Finance

ifoa pensions conference

equities equity

asset classes

equity fx credit

century asset allocation

expected ex ante return

information ratio

typical pension scheme