Standard Life Investments

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1 This presentation is intended for investment professionals Standard Life Investments Stealing Ideas from Your Managers: A CIO's Guide to Tactical Risk Budget Management Emmanuel Matte CFA, FSA, FCIA Vice-President Phone: emmanuel.matte@standardlife.ca August 2012 Warning This presentation is strictly about investment risk management Focus: pension assets but it also applies to most investment framework This presentation may not please some consultants (sorry!) some active managers (less sorry!) some hedge fund managers (not so sorry!) Opportunity is missed by most people because it is dressed in overalls and looks like work - Thomas Edison 2

2 Question? As a CIO, what are you actually paid for? Part of the answer is probably : Adding value over a (specified) benchmark Then ask yourself What is your true benchmark? 3 Is this your benchmark? Asset allocation as of Dec. 31 st of each year More than 25% in non-traditional classes Other Private Equities Real estate / Infrastucture Non-Canadian Equities Canadian Equities Canadian Bonds '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 ' Source: Pension Investment Association of Canada (PIAC) Asset mix of plan sponsor organizations represented by members as at December of each year. 4

3 The true benchmark 3 Broad Type of CIOs Type 1: tal or absolute return focus Don t care about relative performance such as peers or benchmarks Type 2: Liability driven focus Don t care about negative returns as long as they exceed the liability Type 3: Relative to benchmark focus Don t care about negative returns nor my liability know which one just look at the variable compensation 5 What decisions are CIO doing? Level of investment decisions : Strategic asset allocation (policy y mix)? Are you considering liabilities or not? Active managers selection (search for alpha)? Are you adding much value for this? Is your comp. linked only to external alpha? But what about tactical views? You may be already doing it (you all have stories ) Often hidden in the other decisions Question : How can risk be properly managed if not done in an aggregate way? 6

4 Grouping of Investment risks? Benchmark Risk Difference between hedging portfolio (HP) and true objectives (liabilities) Risk-premium Believe there is a premium for risk (over HP) in some classes Liquid asset classes or markets Illiquid asset classes (RE, PE, Infra, etc ) Alpha within asset classes Security selection (micro) & portfolio construction (macro) Opportunistic or relative strategies L/S equity, Managed futures, GTAA, Absolute return, HFunds,... 7 The risk free proxy Tracking (HP vs Liabilities) Return Generating Portfolio Liability Resulting tracking can be referred to as the benchmark risk This tracking risk should be minimized and all deviation (strategic or tactical) from the HP should be seen as risky asset 8

5 Adding Risky Asset Return Generating Portfolio Risky Assets We ecan refer ee tot this sasa a risk pe premium risk Gains from this decision are achieved when Risky assets return > Hedging Portfolio return even if the returns are negative! 9 Investment framework revisited RRBs Gvt Bonds Real Estate CIO #1: Liability = CPI + 4% Risky Asset DEX CIO #2: Liability = 50% DEX + 25% TSX + 25% MSCI World Risky Asset MSCI TSX CIO #3: Liability = Pension Solvency Liability Risky Asset Liability Replicating Bond Portfolio 10

6 Tip You should document the Risky vs. Hedging decision in your investment policy Allocation in risky assets reflect the tolerance to risk ( Risk Budget ) Often the highest (unmanaged) investment risk lerance to risk may be changing (glide path should not be tactical ) 100% Allocation to risky asset given funding ratio 75% 50% Risky Assets 25% 0% 75% 80% 85% 90% 95% 100% 110% 120% Sample Pension Liability Dynamic Risk Management Structure 11 The strategic asset allocation story At the policy level, asset classes are selected Based on longer views and independent of market opinions (i.e. not tactical) and foremost Because they provide excess return over Liability (not necessarily cash ) Food for thought : If your true benchmark is to exceed your liabilities, what is the rationale of a long term risk premium of DEX Long over a replicating LDI portfolio? Insanity is doing the same thing, over and over again, but expecting different results Albert Einstein 12

7 Defining the Strategic risky Asset Allocation Risky Assets Beta #5 Beta #4 Beta #3 Beta #2 Beta #1 This choice of risky asset classes should not be driven by tactical views The risks are best managed by maximising the correlation with the HP portfolio Example: Prefer Global HY over Equity (when HP = pension liability) Prefer Real estate over Equity (when HP = absolute return) Prefer Emerging Markets over MSCI-World (as a substitute for TSX in the HP) 13 The overlay story for pension asset The derivatives overlay decision is motivated by return not hedging Illustration (60/40, assumed bonds = liabilities replicating portfolio) Asset = 40% Bonds + 60% Equity + 60% Overlay = 40% Bonds + 60% Equity + 60% (Bonds Cash) = 100% Liabilities + 60% (Equity Cash) = Liabilities + 60% (risk premium of Equity over cash) Same logic if Equity here is replaced by a more general risky asset 14 14

8 The dynamic or tactical asset allocation story Applying dynamic allocation to the different asset classes Usually poorly managed Requires a hands on approach given the risk on / risk off volatile context May be best to outsource the short-term TAA in an explicit mandate and keep the longer term ones The active management story In traditional asset classes Security selection (micro calls) Constant security selection value added yet to be proven It takes a buyer for every seller Portfolio construction (macro calls) Most of the start managers alpha is due to a limited number of investment ideas Many of these ideas are overlapping with other risk already taken Do you feel you are paying active management fees for beta results? The fact that an opinion has been widely held is no evidence whatever that it is not utterly absurd - Bertrand Russell 16 16

9 Adding tactical risk Alternatives Beta #4 Beta #3 Beta #2 Beta #1 Tactical Portfolio Illiquid asset classes Liquid Betas Benchmark of the Tactical portfolio should be absolute return (eg: Cash + x%) The idea is to be risk focused in order to get a pure alpha profile, as much as possible Can be outsourced to Absolute Return products 17 18

10 Why don t you make tactical views an explicit asset class? A new asset allocation approach where all tactical views (internal AND external) are aggregate into a specific portfolio This would increase investment risk management Hedging portfolio (LDI) Market Beta (Liquid asset allocation) Illiquid Alts Tactital Portfolio Old approach Revised approach 19 Summary Strategic level risk management ( unmanaged investment risk) Define a customized hedging portfolio benchmark that minimizes the difference with the liabilities Allocation to risky asset given funding ratio 100% Decide on a risk budget to deviate from the HP Could be a glide path 75% 50% 25% Risky Assets 0% 75% 80% 85% 90% 95% 100% 110% 120% Allocate risk budget to (can also be in the glide path ) : Liquid market exposure (Beta) Illiquid asset classes (Alts such as PE, RE, Infra, etc ) Tactical portfolio Benchmark = Liability (or Absolute if using an overlay) Hedging portfolio (LDI) Market Beta (Liquid asset allocation) Illiquid Alts Tactital Portfolio 20

11 Summary Tactical level risk management ( managed investment risk) Implement duration strategy for the non-hp asset (overlay / glide path ) Small mandates in active management (pay for micro ideas) Long/Short equity, Concentrated, Winners list Don t forget to capture house views of all active managers Small mandates to multi-assets macro specialists Absolute Return / Managed futures / Dividend Growth Fund / Global Macro (pay for macro ideas) Implement CIO s tactical ideas (risk-factor analysis) Stealing ideas from your managers and implement it in an integrated way Tactical beta overlay (TAA), Currency overlay Views on level of rates 21 Appendix : Any one doing it? 22

12 Pension example Illiquid Asset MSCI (active) Other Alts TSX (passive) DEX (passive) DEX (active) TSX (active) DEX Long (passive) Bonds (active) RE Infra Other alpha Equity Long/Short CIO's budget Private Equity MSCI "futures" Liability Replicating TSX "futures" DEX (passive) There are risks and costs to a program of action, but they are far less than the long-range risks and costs of comfortable inaction" - J.F. Kennedy 23 Extension Making the strategic beta decision can actually be tactical No need to impose constraints on market exposure Easier to capture opportunities Beta can also be decomposed into risk factors and risk managed along with other tactical views Tactical Portfolio Illiquid asset classes Tactical Portfolio (incl. market beta) Illiquid asset classes Liquid Betas 24

13 Real life example Client : Large financial institution pension plan ~80% funded in 2005; needed to de-risk Implemented LDI (hedging portfolio) and derivative overlay Removed all beta constraints and made it tactical with Cash+5% benchmark Implemented risk based analysis / diversification Kept legacy PE and RE explicitly PE RE Bonds Absolute Reurn Liability Proxy (cash +5%) PE Equity RE 25 Structure of this client s Tactical Portfolio Traditional Market returns Stock selection Directional / Opportunistic Relative value Advanced 26

14 Experienced performance 160 Global Equities Return experienced from the client s tactical portfolio Upside capture 30.9% Downside capture -2.9% 70 Managing beta tactically provided an asymmetric correlation Source: Standard Life Investments 27 Risk factors analysis works! Even in recent challenging time MSCI World Return from the client s Tactical portfolio Japan Tsunami US debt loses AAA Source: Standard Life Investments 28

15 Hedge Funds 29 The information shown relates to the past. Past performance is not a guide to the future. The value of investment can go down as well as up. Any data contained herein which is attributed to a third party ("Third Party Data") is the property of (a) third party supplier(s) (the Owner ) and is licensed for use by Standard Life**. Third Party Data may not be copied or distributed. Third Party Data is provided as is and is not warranted to be accurate, complete or timely. the extent permitted by applicable law, none of the Owner, Standard Life** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Past performance is no guarantee of future results. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates. **Standard Life means the relevant member of the Standard Life group, being Standard Life plc together with its subsidiaries, subsidiary undertakings and associated companies (whether direct or indirect) from time to time." Montréal ronto Calgary Investissements Standard Life inc. Standard Life Investments Inc. Standard Life Investments Inc. 1001, de Maisonneuve Blvd. West 121 King Street West The Standard Life Building Suite 1000 Suite th Avenue S.W. Montréal, Québec ronto, Ontario Suite 1500 H3A 3C8 M5H 3T9 Calgary, Alberta T2P 0M9 Standard Life Investments Inc., with offices in Calgary, Montréal and ronto, is a wholly owned subsidiary of Standard Life Investments Limited. Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Standard Life Investments Limited is authorised and regulated in the UK by the Financial Services Authority. Calls may be monitored and/or recorded to protect both you and us and help with our training Standard Life, images reproduced under licence 30