Developing an investment strategy (2)
Developing an investment strategy (2)
deterministic or stochastic model that can be used to help an institutional investor set an investment strategy.
Model will have
a specified objective with a measurable target that refers to assets and liabilities
a time horizon
probability confidence interval (if stochastic)
Model is run and re-run, each time changing the investment strategy, until the stated objective is met.
Model should be dynamic, i.e. allow for correlations between asset and liability cashflows.
Success of strategy is monitored by regular valuations. Results compared with projections form modelling process and adjustments made to the strategy to control the level of risk accepted by the strategy, if necessary.
2 part process:
Deciding how to allocate the max permitted overall risk between active risk, structural risk and strategic risk.
allocating the active risk budget across the component portfolios (e.g. to the UK equity manager, to the UK bond manager).
Process of establishing how much risk should be taken and where it is most efficient to take the risk (in order to maximise return).
An investment style where asset allocations are based on an asset's risk contribution to the portfolio as well on the asset's expected return.
Strategic risk, structural risk and active risk
Risk of under-performance if the strategic benchmark does not match the liabilities
Risk of under-performance if the sum of the individual benchmarks given to fund managers does not add up to the strategic benchmark.
Risk of under-performance if the fund managers do not invest exactly in line with the individual benchmarks that they are given.
Not usually achievable in practice. Instead, the investor might try to hedge liabilities with respect to specific factors.
e.g. immunisation, currency matching, and hedging unit-linked liabilities.
Under unit-linked liability hedging, the price of each unit is determined in relation to the value of the assets. The value of the liabilities, i.e. the units, is then linked to that of the assets.
The assets actually held may not be exactly the same as those underlying the value of liabilities.
If assets are managed by a third party, there may be a lack of knowledge as to what is actually held.
Asset price data used to determine the value of the liabilities may be out of date, by which time the actual asset value has changed.
Assets are chosen in such a way as to perform in the same way as the liabilities.
Generally aimed at meeting fixed monetary liabilities; although it can be applied to I-L liabilities if I-L bonds exist.
The possibility of mismatching profits as well as losses is removed, apart from a small second order effect.
Theory only works for small interest rate changes and assumes a flat yield curve and level interest rate changes at all terms.
Portfolio would need to be arranged constantly so that the three initial conditions are always met.
Dealing costs and tax are ignored
Assets of a suitably ling discounted mean term may not exist
Timing of asset proceeds and liability outgo may not be known.
Conditions for classical immunisation theory to work
PV of liability outgo and asset proceeds are equal
discounted mean terms of the liability outgo and asset proceeds are equal
convexity of asset proceeds is greater than that of the liability outgo
Investment of the assets in such a way that PV(assets) - PV(liabilities) is immune to a general small change in the rate of interest.
Non-actuarial techniques for determining an investment strategy
Mean-variance portfolio theory, without taking into account the liabilities
Basing asset allocations on market capitalisations, e.g. index tracking
Shadowing the investment strategies of competitors (commercial matching)
Measures of active risk
Historic tracking error
i.e. annualised standard deviation of difference between actual and benchmark returns.
Forward-looking tracking error
i.e. estimated standard deviation of relative returns if current portfolio was unaltered
Active + passive management
Where the manager has few restrictions on the choice of investments, perhaps just a broad benchmark of asset classes. This enables the manager to make judgements as to the future performance of individual investments, in both the long term and short term.
expected to produce greater returns (unless the market is efficient) but it carries greater risk and involves extra dealing costs.
holding of assets that closely reflect those underlying a certain index or specific benchmark. The manager therefore has little freedom to choose investments.
Passive management is not risk-free as the index may perform badly or there may be tracking errors
Determining how much strategic and active risk to take
risk tolerance of the stakeholders in the fund.
Systematic risk they are prepared to take on in the attempt to enhance long-term returns.
Whether it is believed that active management generates positive excess returns
Reasons why not normally possible
The timing or amount of asset proceeds or liability outgo may be uncertain, e.g. due to options, discretionary benefits
Pure matching would involve buying excessive amounts of certain securities, which is likely to be prohibitive.
Pure matching would generally require risk-free zero-coupon bonds or strips with exactly the same term as the liabilities, which do not usually exist, or are too expensive.
Some liabilities are of such a long-term that suitably long-dated assets do not exist
Structuring the flow of income and maturity proceeds from the assets so that they will coincide precisely with the outgo in respect of the liabilities under all circumstances.
Conflicting objectives faced by investment funds
To ensure security, i.e. to meet the liabilities
To achieve high long-term investment returns
Mean variance portfolio theory with liabilities
Minimise the variance of the surplus for a given expected return, treating the liability as a negative asset. Surplus at the end of the period is given by:
S= AΣxi(1+Ri) - L