Asset Management and Institutional Investors

Asset Management and Institutional Investors

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Ignazio Basile Pierpaolo Ferrari Editors Asset Management and Institutional Investors Foreword by Andrea Sironi

Editors Ignazio Basile Department of Economics and Management University of Brescia Brescia, Italy Pierpaolo Ferrari Department of Economics and Management University of Brescia Brescia, Italy ISBN 978-3-319-32795-2 ISBN 978-3-319-32796-9 (ebook) DOI 10.1007/978-3-319-32796-9 Library of Congress Control Number: 2016945976 Springer International Publishing Switzerland 2016 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. Printed on acid-free paper This Springer imprint is published by Springer Nature The registered company is Springer International Publishing AG Switzerland

Foreword It is a pleasure for me to present this book devoted to the investment management policy of institutional investors, which a group of friends and colleagues have written with great dedication and expertise, providing a methodical and in-depth perspective of a multifaceted topic that is in continuous evolution. The book is composed of four parts. The first one analyses the different types of institutional investors, institutions which, with different objectives, professionally manage portfolios of financial and real assets on behalf of a wide variety of individuals. The development factors and benefits for the financial system generated by institutional investors are identified, and a comparison is made at the international level. The first part goes on with an in-depth analysis of the economic, technical and regulatory characteristics of the different types of investment funds, assuming the perspective of a European Union investor. Management strategies, restrictions to investment policies, public documentation and charges of investment funds are explored. This section also analyses other types of asset management products which have a high rate of substitutability with investment funds and represent their natural competitors. The second part of the book identifies and investigates the stages of the investment portfolio management, dividing the investment process into the following stages: the identification of the objectives and the constraints of the investment policy, the formalisation of the investment strategy, the implementation of the financial strategy, the periodic rebalancing of the portfolio and the assessment of results and risk control. Given the importance of strategic asset allocation in explaining the ex post performance of any type of investment portfolio, this section provides an in-depth analysis of asset allocation methods, illustrating the different theoretical and operational solutions available to institutional investors. This section focuses on the concepts and applications of traditional approaches to asset allocation, based on mean-variance optimisation, but also deepens the new risk-based approaches for asset allocation, which eliminate estimation risks associated with the traditional approaches. Finally, the second part concludes with a presentation of the methods and instruments for portfolio selection v

vi Foreword available to institutional investors for a more aware identification of the optimal portfolio, taking into consideration management objectives and constraints. The third part describes performance assessment, its breakdown and risk control. The first step in performance assessment is the calculation of return, with the identification of the most appropriate measure among the different methods of calculation available. Performance evaluation requires then the identification of the risk of an investment portfolio, in its different forms of absolute, asymmetric and relative risk, and the calculation of the related risk-adjusted performance measures, which will enable to assess the efficiency of the asset manager with respect to the benchmark, the competitors and the ex ante risk limits. When comparing the performance of competitors, it is essential that homogenous peer groups be created, made up of portfolios with the same management approach. To this end, the most common operational solution is to create a peer group based on the investment style, by using a deductive approach founded on the so-called returns-based style analysis. This section provides alternative methods and utilisation rationales of style analysis. In the case of non-indexed portfolios, an in-depth ex post performance assessment also requires the evaluation of the asset manager in terms of the ability to realise effective stock picking and market timing activities. For this purpose, this section presents the most appropriate performance attribution model aimed to shed light on those management choices that generated the gap between the overall result of the portfolio and the benchmark, breaking down relative performance into its determinants and attributing it to the various factors that contributed to its generation. Finally, the fourth part deals with the subject of diversification towards alternative asset classes, identifying the common characteristics and their possible role within the framework of investment management policies. This section analyses hedge funds, identifying their operational characteristics, management strategies, the regulatory framework and the specific performance assessment techniques. The distribution of the hedge funds returns highlights some statistical anomalies that compromise the validity of normality assumption, which is a necessary condition for the application of classic performance measures. The section continues with a complete and exhaustive analysis of the other types of alternative investments: private equity, real estate, commodities and currency overlay techniques. A common characteristic of these alternative asset classes is to have returns that are often uncorrelated with those of traditional asset classes, although the direction and intensity of the correlation varies greatly over time and according to the specific category of alternative investment. I believe it is worthwhile to highlight three strengths that enrich this work and make it an easy reading and of interest to a wide audience: First, an abundance of up-to-date data and numerical and graphic illustrative tables. This is a very important aspect that facilitates the understanding of even the most complex concepts. Second, the ability to analyse frontier themes in relation to investment management, without underrating the fundamental concepts that lie at the basis of the most advanced research. This feature makes the book of value and of service to experts, who are interested in cutting-edge models and techniques, and also to those who are less experienced on the subject. Lastly, there is the meticulous work done by the editors, who, thanks to the logical

Foreword vii coherence and sequence of the subjects, have succeeded in the difficult task of making a book written by different qualified authors comparable to a manual written by a single author. To conclude, in its thorough and precise analysis of all these subjects, the book edited by Ignazio Basile and Pierpaolo Ferrari is a useful and effective tool for tackling the topic of the investment management policy of institutional investors. Rector of Bocconi University of Milan Milan, Italy Andrea Sironi

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Contents Part I Institutional Investors: Typologies, Roles and Products 1 Institutional Investors... 3 Ignazio Basile 1.1 Institutional Investor Features... 3 1.2 Development Factors............................... 10 1.3 Benefits to the Financial System... 11 1.4 An International Comparison.... 16 References... 29 2 Collective Investment Vehicles and Other Asset Management Products... 31 Pierpaolo Ferrari 2.1 Asset Management Products... 31 2.2 Collective Portfolio Management............... 31 2.3 Investment Funds... 33 2.4 Unit Trust Schemes..... 63 2.5 Open-End Investment Companies........ 64 2.6 Other Asset Management Products..... 66 References... 75 Part II Investment Management Policy 3 Stages of Investment Management Policy... 79 Pierpaolo Ferrari 3.1 Investment Management Policy...... 79 3.2 Identification of Objectives and Constraints.............. 79 3.3 Formalisation of the Investment Policy.................. 82 3.4 Implementation of the Financial Strategy................. 82 ix

x Contents 3.5 Periodic Portfolio Rebalancing... 90 3.6 Performance Assessment and Risk Control..... 92 References... 96 4 Strategic Asset Allocation with Mean-Variance Optimisation... 97 Maria Debora Braga 4.1 Strategic Asset Allocation with Markowitz s Mean-Variance Optimisation..... 97 4.2 The Assumptions of Mean-Variance Optimisation... 104 4.3 Estimation Risk and Practical Problems with Mean-Variance Optimisation..... 110 4.4 The Application of the Markowitz Approach: An Example... 119 4.5 Strategic Asset Allocation and Estimation Risk Management: An Initial Description... 128 4.6 The Additional Weight Constraints Method.............. 129 4.7 The Resampling Method..... 138 4.8 Bayesian Strategic Asset Allocation: The Black-Litterman Model.......................................... 148 References... 170 5 Methods and Tools for Portfolio Selection... 173 Maria Debora Braga 5.1 Portfolio Selection... 173 5.2 Level of Diversification of Optimal Portfolios... 174 5.3 Analysis of Portfolio Risk Using Asymmetric Measures...... 180 5.4 Constraints on Risk-Taking... 189 5.5 Analysis of Future Scenarios of the Cumulative Wealth... 195 References... 200 6 Alternative Approaches to Traditional Mean-Variance Optimisation... 203 Maria Debora Braga 6.1 Alternative Asset Allocation Approaches to Traditional Mean-Variance Optimisation.......................... 203 6.2 The Global Minimum-Variance Strategy................. 205 6.3 The Optimal Risk Parity Strategy... 207 6.4 Portfolio Selection Under Alternative Asset Allocation Approaches... 209 References... 213 Part III Performance Evaluation for Traditional Investment Portfolios 7 Performance Evaluation... 217 Pierpaolo Ferrari 7.1 Performance Evaluation Stages... 217 7.2 Return on an Investment Portfolio...................... 218 7.3 Investment Portfolio Risk Measures..... 236 7.4 Risk-Adjusted Performance Measures................... 244

Contents xi 7.5 Evaluation of Stock Picking Ability..................... 260 7.6 Assessment of Market Timing Ability... 264 7.7 Performance Persistence............................. 267 References... 274 8 Returns-Based Style Analysis... 277 Maria Debora Braga 8.1 The Role of Returns-Based Style Analysis... 277 8.2 Methodological Aspects of Returns-Based Style Analysis..... 278 8.3 An Empirical Application of Returns-Based Style Analysis.... 286 8.4 Rolling Returns-Based Style Analysis................... 293 8.5 An Empirical Application of Rolling Returns-Based Style Analysis... 296 References... 300 9 Performance Attribution... 301 Maria Debora Braga 9.1 Performance Attribution: Definition, Objectives and Assumptions... 301 9.2 Performance Attribution using the Brinson Model.... 305 9.3 Integration of the Currency Effect into Performance Attribution... 315 9.4 Multi-Period Arithmetic Performance Attribution.... 321 References... 323 Part IV Portfolio Diversification Towards Alternative Asset Classes 10 Portfolio Diversification Policies: Alternative Asset Classes... 327 Ignazio Basile 10.1 Alternative Investment Features..... 327 10.2 Alternative Investments from a Portfolio Perspective........ 328 10.3 The New European Union Regulations........... 335 References... 338 11 Hedge Funds... 339 Ignazio Basile 11.1 Hedge Fund Features............................... 339 11.2 Management Strategies...... 341 References... 352 12 Hedge Fund Performance... 355 Roberto Savona 12.1 The Complexity of Hedge Fund Performance Measurement... 355 12.2 Classical Performance Measures....................... 356 12.3 Advanced Performance Measures...................... 362 12.4 Measuring Hedge Fund Performance: An Empirical Application... 366 References... 371

xii Contents 13 Private Equity... 373 Guido Abate 13.1 Private Equity Features..... 373 13.2 Investment Vehicles................................ 374 13.3 Management Strategies...... 382 13.4 Risk and Return Measurement......................... 386 References... 400 14 Real Estate... 403 Guido Abate 14.1 Real Estate Features................................ 403 14.2 Investment Vehicles................................ 407 14.3 Management Strategies...... 420 14.4 Risk and Return Measurement......................... 422 References... 430 15 Commodities... 433 Guido Abate 15.1 Commodity Features..... 433 15.2 Risk and Return of Commodities...... 438 15.3 Commodities Within the Financial Assets Portfolio....... 444 15.4 Investment Vehicles in Commodities... 446 References... 451 16 Currency Overlay... 453 Guido Abate 16.1 Passive Versus Active Currency Overlay................. 453 16.2 Passive Currency Overlay..... 455 16.3 Active Currency Overlay... 462 References... 467

List of Contributors Guido Abate Department of Economics and Management, University of Brescia, Brescia, Italy Ignazio Basile Department of Economics and Management, University of Brescia, Brescia, Italy Maria Debora Braga Department of Economics and Political Science, University of Valle d Aosta, Aosta, Italy SDA Bocconi School of Management, Bocconi University, Milan, Italy Pierpaolo Ferrari Department of Economics and Management, University of Brescia, Brescia, Italy SDA Bocconi School of Management, Bocconi University, Milan, Italy Roberto Savona Department of Economics and Management, University of Brescia, Brescia, Italy xiii