Current Investment Issues
Florent Salmon, VP Portfolio EngineeringNovember 20th, 2009
Current Investment Issues
Florent Salmon, VP Portfolio EngineeringNovember 20th, 2009
2009 General Meeting ● Assemblée générale 20092009 General Meeting ● Assemblée générale 2009
Canadian Institute
of Actuaries
Canadian Institute
of Actuaries
L’Institut canadien desactuaires
L’Institut canadien desactuaires
Ottawa, Ontario ● Ottawa (Ontario)Ottawa, Ontario ● Ottawa (Ontario)
2
Executive Summary
General Framework– Relative weights of money management functions
Portfolio Insurance– Entry barriers and common issues
Alternative Beta– Concepts and characteristics
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ALM(interest rate)
Risk Budget(long term objective)
Asset Allocation(Sharpe ratio)
Risk Budget, Insurance
Immunisation,Passive hedging60/40
Relative Market Views
Money management functions (pension funds)
Only one management tool to achieve three distinct and often conflicting objectives
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Liability Driven Investing (LDI) & Leverage Leverage allows to decouple asset selection and risk management Managers can focus on relative value and liquidity profile (Sharpe ratio) Immunisation (interest rate hedging) is a simple passive protocol. It defines the benchmark.
Immunisation Asset(with/without overlay)
Liabilities
Asset Allocation(Returnprofile)
Risk Budget(sizing)
Maximization of Sharpe ratio Investment objectives
Not
a
focu
sN
ot
a fo
cus
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Importance of asset allocation
Too much emphasis on asset mix and not enough on risk management Asset mix only goal is to maximize Sharpe ratio. Risk budgeting and
Insurance will rescale the return pattern so that it fits investor requirement
Asset Allocation SelectionRandom 1.5 year Periods since 1985
SPX,TSX, Global Bonds
-500
0
500
1000
1500
2000
2500
-40.0% -30.0% -20.0% -10.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0%
Annual Return
# o
f S
ce
na
rio
s
Random Selection (vol. 60/40) 60/40
This is just CAPMThis is just CAPM
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LDI + Conditional Risk Budget
Portfolio insurance = Dynamic Risk budget
Fix Risk Budget
Return
Return – Insurance Cost
Conditional Risk Budget
must be set beforehand (objective and protocol)
Insurance helps dealing with intermediary risks
Only way to avoid Black Swan scenarios
Nature of the obligation of a pension fund is a collar
Insurance protocol is set beforehand and its efficiency is measurable
Must be internalised!
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Pension assets: Collar profile
Surplus : Contribution break
Deficit : Impact on Corporate Benefits
Market Level
Return on Pension Fund assets
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Risk Tolerance
Long-term investor doesn't exist. Bankruptcy risk is always a possibility.
The most important thing is to define risk objectives (horizon). Running the protocol that allows to meet these objectives is fairly easy.
2008 crisis and the weakness of solvency ratio: are we changing our "modus operandi"
Framework is valid for institutional investors and retail investors
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Solvency Dilemma
Solvency
40
50
60
70
80
90
100
110
120
130
140
0 10 20 30 40 50 60 70 80 90 100
Weeks
Ind
ex (
Re
turn
)
Basic Scenario Conservative Scenario
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Solvency Dilemma (continued)
Solvency
40
50
60
70
80
90
100
110
120
130
140
0 10 20 30 40 50 60 70 80 90 100
Weeks
Ind
ex (
Ret
urn
)
Basic Scenario Aggressive Scenario
Portfolio InsurancePortfolio Insurance
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Objectives
Avoid dramatic losses while maintaining an advantageous participating rate in favorable markets
Fit the invesment return profile to investor's utility function Key stake is the internalisation of insurance protocol
(delta)– Allows costs minimization, a tailored strategy (when needed) and facilitates
modifications– Models have been known and used for many decades– Options offered by brokers are often inadequate (discomfort for the one
year and over segments) – Since the option (insurance) associated with a pension fund is over a long
period, frequency of rebalancing is low.
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Objectives (continued)
Implementation : Portfolio insurance is typically handled as an overlay on the existing pension fund position – No change to the existing management process– Easier efficiency measurements
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Buying Listed Put Options
• Systematic Market Insurance is very expensive
• 1.7% premium paid on positive years on average
• Not optimal for long term investments
60/40 60/40 + Option
Return 0.78% 0.35%
Vol. 9.29% 9.04%
Min. -16.08% -8.34%
Max. 11.86% 8.25%
Corr. 100.00% 99.24%
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Variable Insurance Portfolio
• Dynamic insurance is more efficient
• No premium paid on positive years on average
• The paid insurance premium is usually small in market growth cycles
60/40 60/40 +
Insurance
Return 0.78% 2.39%
Vol. 9.29% 5.83%
Min. -16.08% -8.38%
Max. 11.86% 11.01%
Corr. 100.00% 91.93%
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Internalisation of Insurance Management Process
• Portfolio insurance allows for a quick and effective adjustment of asset allocation to market environment
• Goes beyond standard fixed risk budgeting
• Fully liquid and transparent• No counterparty risk involved• Can be adjusted at any time,
with no fees, to take into account new risk constraints
• No market depth limitations• Low cost
Avantages
Alternative BetaAlternative Beta
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Risk premium and indexation
Recent crisis will favor passive beta (indexation) with liquidity, low fees and no counterparty risk.
Whether you believe in active management or not, index products create useful tradable benchmarks in all markets
How many pure risk premiums are available?
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Basis for Alternative Beta Products
Academic research and increased competition have helped change the dominant paradigm that hedge funds are pure absolute return investment products.
Traditional Assets
Beta Return
Alpha Return
To
tal Re
turn
AlternativeAssets
Beta Return
Alpha Return
TraditionalAssets
Beta Return
Alpha Return
Alternative Assets
Beta Return
Alpha Return
Dominant Paradigm : 1960-2000 Emerging Paradigm : 2000-current
Basis for the creation of index funds and hedge fund replication : Common sources of return
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Reasons for the Apparition of Alternative Beta Funds
Hedge funds main criticisms– Insufficient transparency– Insufficient liquidity– Heavy fees structure– Complex and hard to explain – Insufficient capacity– Reputation risk
Some investors agree with the initial hedge fund proposition (absolute return) but not in its current format (transparency, fees)
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Alternative Beta Categories
Main objective is to replicate the risk/return characteristics of hedge fund investments or of indices and to avoid
aforementioned drawbacks.
Factor based– Captures hedge fund managers asset allocation decisions
Rule based replication– Reproduces in a systematic fashion certain management
strategies used by hedge fund managers
Synthetic Payoff– Reproduces on a synthetic basis the risk-return profile and
correlation of a fund
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Principles of Factorial Approach
90 % of a manager's return (alternative or not) is justified by main asset allocation decisions– Exchanges– Currencies– Interest rate– Corporate credit– Resources/Metals– Money Market
Factor-based replication aims to capture the main allocation decisions while ignoring marginal positions
Tradable factors (futures)
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ResultsGlobal HF Indices vs Replication
70
80
90
100
110
120
130
140
150Credit Suisse Tremont Hedge Fund
Credit Suisse/Tremont Blue Chip Hedge Fund
Credit Suisse/Tremont Blue Chip Hedge FundMulti-StrategyHFRI Fund Weighted Composite
HFRX Global Hedge Fund
HFRX Equal Weighted Strategies
Replication (DGAM SAI)
Non investable
Investable
SAI
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Management Protocol Approach
Alternative Beta Strategies Performance
50
70
90
110
130
150
170
190
210
230
250
Ind
ex
(R
etu
rn)
S&P 500
60/40 Portfolio
FX Carry Trade
Commodity Spread
Diversified Momentum CTA
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Strategies Examples
Carry Beta
Barclays FX CTA
Return 4.92% 2.10%
Volatility 4.90% 4.67%
Correlation 10.02% 7.02%
Carry Trade :Profit from the premium
embedded in the forward contracts of higher yielding currencies
It's not arbitrage; it's a risk premium, but a different risk premium therefore diversifying.
Comm. Beta
Barclays Commodity
CTA
5.09% 4.06%
2.51% 7.13%
-1.60% 11.54%
Commodity Spread :Profit from variations in the convenience yield
and market cyclicality in the commodity space
Momentum Beta
Barclays Momentum
CTA
6.49% 5.86%
9.01% 11.19%
-37.88% -19.61%
Momentum Diversified CTA :
Profit from exposure to market trends (both up
and down) across different asset.
ConclusionConclusion
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Conclusion : fiduciary responsability Risk Management ≠ Risk control and asset mix
– In order to add value, asset selection should be made independant of risk management (key concept for hedge funds)
Portfolio insurance– Proactive– Better fit to client requirements (maximum loss over different
horizons)– Room for improvement
Alternative Beta– Return, liquidity, transparency
Fees and desintermediation– Alternative beta: a quarter of hedge fund fees – Portfolio insurance: Sell side vs. Buy side
Convergence
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Questions / Comments
Everything should be made as simple as
possible, but not simpler.
Albert Einstein
