Dynamic Asset Allocation within the long-term strategic risk budget is profitable

Dynamic Asset Allocation within the long-term strategic risk budget is profitable

Dynamic Asset Allocation within the long-term strategic risk budget is profitable Summary For long-term investors it is common to design a long-term investment strategy, which aims to generate return to reach their objectives (e.g. long-term benefit payments). However, every investor knows that a lot can happen between now and the long term. A good example is the current low yield environment, the potential reversion to higher interest rates and the impact this may have on equity returns. The definition of a strategic risk budget enables to act on such market circumstances, in a controlled way without violating the long-term investment strategy. It facilitates Dynamic Asset Allocation (DAA) for top-down risk on/ risk off decisions in addition to the long-term strategy. The main question that of course arises is which signal to incorporate when making these risk on / risk off decisions. Research shows that the OFS risk and return projections are beneficial in this DAA process. First of all to support the DAA decision to generate additional return. Second, to evaluate whether the DAA is compliant with the strategic risk budget, based on a consistent methodology. Portfolio construction back-test (1999-2017) shows clear added value of OFS for annual DAA decisions to generate excess return compared to a static SAA. This article presents the results of a back-test (1999-2017), which shows clear added value of OFS for annual DAA decisions to generate excess return compared to a simple static Strategic Asset Allocation (SAA). 2

The OFS for asset allocation decisions and risk management The OFS provides dynamic stochastic scenarios with up to date and realistic expectations of risk and returns for both shortterm and long-term horizons. Its design is based on the premise that there is an underlying structure in how markets tend to fluctuate in reality. These empirically evidenced tendencies (also called stylized facts ) are integrated in the OFS at a global scale and across asset classes. The OFS takes into account the actual economic and financial market circumstances, as well as the effects of interventions by central banks and governments. The OFS integrates different time horizons, producing realistic short-term and long-term scenarios in one framework. By integrating these in one scenario set, it is possible to consistently combine long-term and short-term asset allocation decisions and risk management. Do the dynamic risk and return expectations of the OFS lead to better dynamic allocation decisions within the long-term risk budget? To answer this question we performed a back-test that is the subject of this article. 3

Successful back-test Dynamic Asset Allocation with OFS for 1999-2017 The back-test (see box) shows that a dynamic strategy, based on risk and return expectations from the OFS, clearly adds value: it delivered an additional annual return in almost all years (net of transaction costs). Obviously, the back-test is a stylized experiment, but it has been set up as objectively as possible. In practice, next to the signals provided by the OFS, other arguments may of course play a part in choosing a (dynamic) allocation. The results of the back-test are summarized in two ways: the annual DAA (allocations) and the annual outperformance of the SAA (performance). Back-test SAA vs DAA Risk Off Risk On Risk Off SAA: 15% illiquid (not in DAA) Risk On SAA: 35% equity 80% 80.0% Risk off Risk on Risk off Risk on 6% 5% 70% 70.0% 4% 60% 60.0% 50% 50.0% SAA: 20% Corporates 40% 40.0% SAA: 30% Goverment bonds 30% 30.0% 20% 20.0% 3% 2% 1% FI Goverment Government Bonds FI Bonds FI Corporate Corporate Bonds FI Bonds Equity Equity Alternatives Alternatives Figure 1: annual Dynamic Asset Allocation 2017 2016 2015 2014 2012 2013 2011 2010 2009 2007 2008 2005 2006 2003 2000 2016 Dec-16 2015 Dec-15 2014 Dec-14 2013 Dec-13 2012 Dec-12 2011 Dec-11 2010 Dec-10 2009 Dec-09 2008 Dec-08 2007 Dec-07 2006 Dec-06 2005 Dec-05 2004 Dec-04 2003 Dec-03 2002 Dec-02 2001 Dec-01-2% 2000 Dec-00-1% 0.0% 0% 1999 Dec-99 10% 10.0% 2004 0% 2002 90% 90.0% Excess return DAA 2001 100% 100.0% DAA-SAA Figure 2: annual outperformance of DAA versus SAA (net of transaction costs) 4

Back-testing approach Objective: We chose to analyze the years 1999 to 2017, and measured how a hypothetical investor who followed the recommendations of the OFS to shape its DAA (on an annual basis) would have performed. We compare these results to those of an investor who on an annual basis rebalanced back to its static SAA. Transaction costs and a one-month implementation time are incorporated. Method SAA, DAA and risk budget: We base our test on a hypothetical investor with a SAA aimed at a long-term horizon, and a risk budget. The investor used the OFS on an annual basis to reallocate between government bonds, corporate bonds or equities. It is restricted to a 10% allocation bandwidth from the SAA, which is a reflection of the strategic risk appetite. Every year, optimization techniques translate the OFS risk and return expectations at that time to an optimal DAA over these three asset classes (within the allocation bandwidths), in order to act on, and profit from, actual market conditions. Out-of-sample back-test: For this test, we only used the knowledge and data that were available at the time as input for the annual historical OFS (out-of-sample). While analyzing the results of such a historical investment analysis, a typical investor would think back and evaluate whether the risk on/risk off decision would have been intuitive at the time. A glance at the history provides an interesting overview: 2000-2002 risk off Good decision Positive financial market conditions (business cycle) during 1999, the end of this phase of the economy is within sight in OFS For DAA it is recommended to reduce equity exposure This downturn became reality (burst tech bubble), together with a decline of interest rates with consequent positive fixed income returns 2003-2005 risk on Good decision OFS expects the business cycle to recover from its downturn Consequent indication for DAA: overweight equity at a cost of fixed income This is in line with the realized positive market developments 2006-2008 risk off Good decision for 2008, though too early (2006/2007) 2009-2017 risk on Good decision Positive phase of the economy (business cycle) has been going on for some time now and OFS expects an economic downturn Recommendation for DAA to tilt fixed income, at a cost of equity Although the downturn didn t occur until 2008 and some return was consequently missed in 2006 and 2007, cutting down on risk proved to be a prudent move OFS expects markets to recover from the crisis with the consequent indication for DAA to overweight equity at a cost of fixed income Accommodating monetary policy continues with resulting positive financial market conditions and further interest rate declines Both equity and fixed income perform well during this period, while the DAA tilt to equity still provides additional return 5

Concluding remarks Over the years, scenario analysis has proven itself to be an essential method to support investment decisions and the monitoring of those decisions. As an expert in this area, there is a lot more to discover about Ortec Finance s OFS and the consistent, realistic and worldwide stochastic scenarios it provides. You can find out more at http://www.ortec-finance.com/en/solutions/economic-scenarios. The added value of the OFS A few years ago, Ortec Finance took the OFS to the next level by adding a new generation of scenario models. The current OFS is itself back-tested extensively for a wide variety of financial-economic variables (see Boer and Steehouwer (2016)). These back-tests clearly show that the scenarios developed by Ortec Finance perform better than simpler scenario models. The back-test for dynamic asset allocation with the OFS shows the added value from an investors perspective. Come talk to us! If you have questions about the OFS, or want to know more about the other services that Ortec Finance has to offer, don t hesitate to get in touch with our contact person Tessa Kuijl at Tessa.Kuijl@ortec-finance.com. 6

About Ortec Finance Ortec Finance is a global provider which designs, builds, and applies software for asset-liability management, ex-ante and ex-post risk management and performance measurement and attribution. The success of Ortec Finance s scenarios is illustrated by the fact that they are used by institutional investors around the world, such as pension plans, insurers, sovereign wealth funds and asset managers. Banks have also adopted the scenarios to support their private clients. Rotterdam Boompjes 40 3011 XB Rotterdam The Netherlands Tel. +31 (0)10 700 50 00 Amsterdam Naritaweg 51 1043 BP Amsterdam The Netherlands Tel. +31 (0)20 700 97 00 Toronto 250 University Ave. #200 Toronto, ON M5H 3E5 Canada Tel. +1 416 736 4955 Pfäffikon Poststrasse 4 8808 Pfäffikon SZ Switzerland Tel. +41 (0)55 410 38 38 London Bridge House 181 Queen Victoria Street London, EC4V 4EG United Kingdom Tel. +44 (0)20 3770 5780 Hong Kong Unit 211, Building 12W, Phase 3 Hong Kong Science Park Shatin, Hong Kong Tel. +852 24779288 www.ortec-finance.com insights.ortec-finance.com