Seeking diversification through efficient portfolio construction (using cash-based and derivative instruments)

Transcription

1 The Actuarial Society of Hong Kong Seeking diversification through efficient portfolio construction (using cash-based and derivative instruments) Malcolm Jones FFA 31 st March 2014

2 My disclaimers A foreword The views represented are my own as are any errors I work for Standard Life Investments on multi-asset and fixed income investment solutions Mainly for defined contribution and defined benefit pension plans I am a qualified actuary..but I am not a regulatory actuary focused on insurance capital management issues 2

3 My investment background Equity investor Japan s bear market beginning USA s bull market and start of technology bubble: Asia s currency contagion and Emerging market stresses: Fixed income investor The birth of the Euro debt markets The start of the credit boom Regulatory capital efficient investment strategies Investment solutions Liability Driven Investment (LDI): risk reduction and risk recycling The advent of Absolute return investment solutions The growing breadth of bond investing The increasing attraction of less liquid investments and solvency 2 The investment world is rarely boring and always challenging 3

4 Background Initial Working party paper prepared presented at Risk and Investment Management conference, UK, June 2012 Sessional paper presented to actuaries in Dublin, London and Edinburgh in 2013 Themes Measurement of portfolio diversification Diversification benefits of unconstrained multi-asset investment Use of derivatives to implement investment strategies Risk measurement of an unconstrained multi-asset portfolio Question Where does the actuarial profession believe it has most to add in the realm of portfolio construction? 4

5 Annualised % return Traditional approach fails to deliver consistent returns Annualised rolling 3 year returns Traditional Balanced Fund Annualised rolling 3 year returns 25.0% 20.0% 15.0% 10.0% Typical return expectation 5.0% 0.0% -5.0% % -15.0% Source: Standard Life Investments Uncertainty is the only certainty there is 5

6 Portfolio diversification measures No single measure of diversification Growing academic literature on measures of systemic risk Need for some definite measures of diversification: Assess current state of the world Observe how it is changing through time We want to consider measures for: Diversification in a given portfolio Diversification potential in an investment universe 6

7 Measuring diversification different methodologies Principal Components Analysis Breaks down total risk of multi-asset portfolios into independent factors Effective factors answers the question how many factors do you need to explain the risks of the portfolio? uses Entropy principles to determine optimum number Iterative Beta Removal Breaks down the variance of portfolio by underlying componentry of the fund Statistically, this is similar to forward-stagewise regression Entropy techniques again used to determine an optimum number of strategies 7

8 Effective strategies Balanced Fund total return index Effective number of assets in UK pension portfolio Total return index Effective number of strategies (lhs) Diversification Potential (lhs) Mar 04 Aug 05 Dec 06 May 08 Sep 09 Jan 11 Jun Low number of effective assets reflects dominance of equity and interest rate risk 8

9 Effective strategies Global equity index Effective factors for unconstrained multi-strategy portfolio Global Equity index Effective number of strategies (lhs) UK balanced Mar 04 Aug 05 Dec 06 May 08 Sep 09 Jan 11 Jun Portfolio s greater number of moving parts allows for more return consistency Source: Standard Life Investments 9

10 Defining the investment challenge How can I build a better diversified investment portfolio but without impacting long term return expectations? Allow a broader global investment universe currencies asset classes and sectors yield curves across different geographies volatility A number of these strategies (such as specific currency pairs) will necessitate the use of derivative contracts Allow unconstrained dynamic asset allocation offers access to the full diversification potential of the chosen investment universe 10

11 Shock absorbing potential (Correlation to global equities) Money making strategies and diversification Global REITs European equity Chinese equity High yield credit Mexican government bonds Euro corporate bonds Australian forward-start interest rates US equity tech v US small cap US Dollar v Canadian Dollar Greater diversification Interest rates Relative value Currencies Source: Standard Life Investments, APT, 24 December 2013 Numerous strategies that can make money in down equity markets 11

12 Portfolio Themes choice of implementations Multi-Speed Global Growth Implementation choices Relative value Duration Europe vs US and Japan Physical and/or interest rate swaps/bond futures US Equity Technology vs Taiwan Physical and/or equity market futures/options German vs French Equity Physical and/or equity market futures/options Central Bank Policy European Duration (Forward-Start) Interest rate swaps Japanese vs Korean Equity Physical and/or equity market futures/options US Dollar vs Japanese Yen Currency forwards / options Earnings Potential European Equity Physical and/or equity market futures/options Global Equity Oil Majors Physical investments Global REITS Physical investments Chinese Economic Change Chinese Equity Physical and/or equity market futures Mexican Peso vs Australian Dollar Currency forwards / options Australian Short Term Duration Interest rate swaps Maximising insights on global investment markets 12

13 Risk-based portfolio construction size 25% 20% 15% 10% 5% Nominal holding Volatility risk 0% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% US Dollar v Canadian Dollar Global equity Stand - alone risk US Dollar v Global equity Canadian Dollar Japanese v Chinese equity Korean equity Japanese v Chinese equity Korean equity Source: Standard Life Investments, sample absolute return portfolio, December 2013 Mexican Government Bonds Mexican Government Bonds High yield credit High yield credit Australian short-dated interest rates Australian short-dated interest rates EU corporate bonds EU corporate bonds Stand-alone risk aligns size of position with its volatility 13

14 100% global equity Expected risk Volatility % Diversificaiton benefits Risk-based portfolio construction Seek a wide range of return-seeking risks 14% 12% 10% 8% 6% 4% 2% 0% Source: Standard Life Investments, sample Absolute Return portfolio, APT system, December

15 Modelled losses % Historical scenario analysis testing for unintentional concentrations of investment risk Global equities Absolute return portfolio 0% Bank Meltdown 2008 Equity Sell-Off 2002 Emerging Euro Crisis Market Sell-Off 2011 QE jitters Asian Crisis 1997 Rate Rise 94-5% -10% -15% -20% -25% -30% Source:Sample absolute return portfolio,us$, Riskmetrics, Dec 31 st

16 Forward scenario analysis Typical problems in scenario analysis Over-reliance on historical quantitative relationships Insufficient qualitative expert judgement Some overarching principles for improvement Focus on potential portfolio weaknesses, not spurious numerical accuracy Explore extreme outcomes Consider a range of perspectives Do not be constrained by conventional statistical methods References: Stress testing at the IMF, IMF (2008) Principles for sounds stress testing practices and supervision, BCBS (2009) Stress and scenario testing, FSA (2009) Macrofinancial stress testing principles and practices, IMF (2012) Better to be approximately right than exactly wrong 16

17 Forward scenario analysis - China Crisis Mathematical issues Equity -37%, Absolute return -6% - How to create fat tails? - Multi-regime Monte-Carlo simulations - How to blend expert opinion? - Entropy pooling Organisational issues - How to identify and scope crises? - How to mitigate group think in defining crises? 14% 12% 10% 8% 6% 4% 2% 0% Sample Absolute return portfolio Equity 17

18 Fund Governance UCITS regulated Sophisticated fund Daily VAR calculations Maximum permitted investment risk With and without diversification benefits Diversification risk parameters Different asset classes Concentration limits Leverage Gross exposure limits Comprehensive set of fund governance parameters 18 1

19 Investment governance and oversight Independent risk analysis Forward looking and historical scenario analysis New instrument approval controls Modelling and understanding benefits and risk Back-office implications Range of counterparties Regulatory considerations Counterparty risk management Counterparty selection Permitted instruments Maximum exposures Collateral management Comprehensive governance, risk and compliance infrastructure is essential 19 1

20 Summary Increasing work focusing on understanding and communicating diversification Line of investment work ideal for actuaries to specialise in Additional input into scenario analysis testing Combining traditional assets with derivative-implemented strategies produces more risk efficient portfolios increase the likelihood of good outcomes for your portfolio Sophisticated funds require a high level of fund-based governance within a multi-level investment risk management infrastructure 20