Thoughts on Asset Allocation Global China Roundtable (GCR) Beijing CITICS CITADEL Asset Management www.bschool.nus.edu.sg/camri
1. The difficulty in predictions A real world example 2. Dynamic asset allocation real world examples 3. Traditional investment approach 4. The role of alternative investments such as hedge funds 5. The alpha imperative: optimal selection to uncorrelated alpha source 6. Seeking exposure to skill and liquidity risk premia 7. Optimal strategy mix to improve portfolio risk profile 8. Conclusion & discussion 2
Big Banks US$ Outlook for 2010 (dated Jan 2010): US$ has limited downside with respect to Yen and Euro. Cyclical near-term weakness followed by gradual dollar recovery further out If global economic growth disappoints, US$ will strengthen US$ will remain weak but strengthen in late 2010 US$ downside limited, in fact likely to rally significantly against Euro, especially given the US$-funded carry trade is probably overdone FORECASTING ASSET RETURNS IS A DIFFICULT BUSINESS TO BE IN! 3
Euro Yen SG$ versus US$ Source: Bloomberg USD strengthens against EUR USD weakens against SGD, JPY 4
Liquidity, Transparency, and Downside Risk Control & Management have become paramount concerns of investors, governments and corporate management Diversification helps but that does not mean a well-diversified basket of stocks are as safe in the long run. If they were safe in the long-run: they wouldn t command a risk premium longer-term put options (a.k.a. insurance) on stocks with a floor rising at the riskless rate would be cheaper than their shorter-term counterparts Absolute return strategies deserve a closer look in the modern capital allocation program 5
Co mp o u n d A n n u a l Re tu r n 5 0.0 % 4 5.0 % 4 0.0 % 3 5.0 % 3 0.0 % 2 5.0 % 2 0.0 % 1 5.0 % 1 0.0 % 5.0 % 0.0 % - 5.0 % - 1 0.0 % - 1 5.0 % - 2 0.0 % - 2 5.0 % - 3 0.0 % R eturn Percentiles 1 3 5 10 20 Time ( Y e a r s ) 9 5 th Pe r c e n tile Ex p e c te d V a lu e 5 th Pe r c e n tile 1 th Pe r c e n tile 0.5 th Pe r c e n tile Pr o b a b ility 1 0 0.0 % 9 5.0 % 9 0.0 % 8 5.0 % 8 0.0 % 7 5.0 % 7 0.0 % 6 5.0 % 6 0.0 % 5 5.0 % 5 0.0 % 4 5.0 % 4 0.0 % 3 5.0 % 3 0.0 % 2 5.0 % 2 0.0 % 1 5.0 % 1 0.0 % 5.0 % 0.0 % Target Probabilities 1 3 5 10 20 Target = 6 % T im e W e a lth ( US D ) 30 10 W ealth Percentiles ($b) Volatility of average compound rate of return on stocks declines with the length of time horizon. 1 Probability of a shortfall declines with the length of time horizon. 1 1 3 5 10 20 Time ( Y e a r s ) 9 5 th Pe r c e n tile Ex p e c te d V a lu e 5 th Pe r c e n tile 1 th Pe r c e n tile 0.5 th Pe r c e n tile However, the severity of the shortfall (the penalty of being wrong function) increases with the length of time horizon 6
Based on Historical Returns From Jan 2002 to Aug 2011 Source: Bloomberg EMERGING MARKETS CANNOT BE ENTIRELY CHARACTERIZED BY THEIR FIRST TWO MOMENTS 7
Feb-88 Feb-89 Feb-90 Feb-91 Feb-92 Feb-93 Feb-94 Feb-95 Feb-96 Feb-97 Feb-98 Feb-99 Feb-00 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Regime State Probability (in %) Source: Bloomberg 1.00 0.90 0.80 0.70 0.60 0.50 Latin Eastern America Europe China India Annualized Returns in State 1-1.57 0.02-1.57 0.38 Volatility in State 1 37.79 36.22 37.79 31.26 Annualized Returns in State 2 18.76 20.04 18.76 0.75 Volatility in State 2 136.64 112.13 136.64 46.72 0.40 0.30 0.20 0.10 0.00 Probability of State 1 0.90 0.90 0.90 0.55 Probability of State 2 0.10 0.10 0.10 0.45 p12 Probability of Transition - State 1 to State 2 0.04 0.01 0.04 0.02 p21 Probability of Transition - State 2 to State 1 0.40 0.12 0.40 0.03 p11 Probability of Remaining in State 1 0.96 0.99 0.96 0.98 p22 Probability of Remaining in State 2 0.60 0.88 0.60 0.97 Asia Latin America Eastern Europe China India AGAIN, EMERGING MARKETS CANNOT BE ENTIRELY CHARACTERIZED BY THEIR FIRST TWO MOMENTS 8
Equity Risk Premium Liability Risk Premium Alpha: Active Risk Duration Risk Currency Risk Credit Risk Inflation Risk Proportion of Risk relative to liabilities (%) TRADITIONAL INVESTMENT APPROACH Aims to maximize returns and minimize risk in a mean-variance framework Primarily relies on long-only equity exposure to deliver long-term outperformance Reliance on managers outperforming index or peer group benchmarks By construction, high correlation with market 50% 45% 40% 35% 30% 25% 43% Risks concentrated in one area 20% 16% 15% PROBLEMS IN TRADITIONAL APPROACH 15% 10% 5% 8% 7% 6% 5% Ignores modern capital market developments 0% Too much reliance on equities and equity managers constrained alpha generation capability No downside protection due to large beta exposure Source: Credit Suisse CURRENT ALLOCATIONS HAVE EQUITY RISK PREMIUM AS DOMINANT RISK FACTOR
Ageing population and changing demographics in Japan, Hong Kong, Singapore and other parts of Asia. Declining support ratios As a consequence, expect compressed equity risk premiums and disappointing long-only equity returns An attendant issue: the development of cutting-edge financial solutions to meet investment and retirement planning needs Hedge funds, alternative investments, principal-protected and/or inflation-linked investment products, equity-indexed guaranteed life annuities (a.k.a. ratchet or click funds), etc. 10
Return-seeking (well-diversified) portfolio: Equities, hedge funds, portable alpha, commodities, real estate, private equity Matching (or hedging ) portfolio: Fixed income, laddered bond portfolios (including active management, high yield, EM debt) Interest rate and inflation total return swaps Equities Real estate Hedge funds Private equity Portable alpha Fixed Income TR Swaps Forwards + Futures Options Return Seeking Downside Protection = Insurance (Risky Portfolio) Matching (Asset-Liability Management) DOWNSIDE PROTECTION (Insurance) PERFORMANCE + RISK REDUCTION = DIVERSIFICATION, ASSET-LIABILITY MANAGEMENT AND RISK MANAGEMENT VIA FINANCIAL ENGINEERING 11
Proportion of Assets (in %) Current developments in the Institutional space More emphasis on risk control and risk budgeting Reduced risk premium opportunities across asset classes substitution from compressed beta risk premia exposure to alternative investments exposure Low correlation with traditional assets and high information ratios Risk mitigation via lower relative portfolio beta exposure Diversification by capturing different risk premia Improved portfolio efficiency by reducing risks without sacrificing returns 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 39% 60% 54% 26% 7% 14% Global Capital Global Pension Funds Other Bonds Equities Source: Credit Suisse THE NEED FOR ALTERNATIVE SOURCES OF RETURN TO OFFSET COMPRESSED RISK PREMIA 12
Exploit Manager Skills Exploit unconstrained manager skills to capitalize on orthogonal alpha opportunities Improve Financial Efficiency Improve portfolio efficiency by reducing risks without sacrificing returns Introduction of Alternative Investments with high information ratios to improve the expected financial efficiency of institutional clients assets, resulting in a greater expected overall return for the overall risk taken. Increase Diversification Across Risk Premia Diversification achieved by capturing different risk premia Mitigate Institutional clients substantial equity risk exposure by seeking independent (orthogonal) sources of return Credit risk premium Liquidity premium Skill premium (securities selection, tactical allocation) 13
Current developments in the institutional space Strategic Asset Allocation and Optimal Use of the Risk Budget 1. Efficient use of the risk budget to enhance returns and mitigate portfolio risks Optimal combination of passive exposure (beta) and active risks (alpha) 2. Increased use of absolute return strategies and alternatives investments Increased exposure to orthogonal sources of return (addition of uncorrelated alpha) Selection of Strategies based on Skills and Diversification Potential 3. Innovations in beta space: capturing systematic alpha effects in index plus form Capturing inefficiencies and enhancing return potential at the index level (130/30 long/short extension, exotic ETFs) 4. Alpha-Beta separation, selection and portfolio optimization Efficient use of capital with minimum footprint on strategic asset allocation policies 14
Efficient use of the risk budget An increased focus on risk budgeting and risk control Specification of an ex-ante risk budgets Optimal diversification across risk premia Reduction of relative portfolio beta risk exposure with orthogonal alpha strategies A new framework for optimal asset allocation Constrain equity market beta to client s utility function Introduce the full spectrum of alternative investment solutions and uncorrelated sources of alpha such as hedge funds Introduce assets with built-in inflation hedges TIPS, IL-GILTS, Commodities Conduct a dual optimization exercise: joint beta and alpha optimization process ALTERNATIVE INVESTMENT STRATEGIES AS A SIGNIFICANT GENERATOR OF UNCORRELATED RETURNS 15
HEDGE UNWANTED EXPOSURES & TARGET DESIRED EXPOSURES Risks with low return potential Currency risk Duration and Convexity risks Longevity Risk Inflation risk Examples: Non-domestic equity exposure: Introduces currency risk Full or partial hedging can reduce impact Non-domestic equity exposure: Introduces exposure to interest rates and inflation Hedge to reduce to a tolerable level Risk exposures with high return potential Manager Skill (Active management, Hedge funds) Liquidity Risk (Private Equity, Small and Micro Caps) Real Estate, Commodities, Credits Aim is to reduce portfolio volatility and maintain or enhance returns 16
Source: Bloomberg Skewed to the right LOW CORRELATIONS TO TRADITIONAL ASSET CLASSES & POSITIVE SKEW RESULTED IN HIGH INCREMENTAL RETURNS FOR LOW MARGINAL RISKS 17
On a historical basis, an allocation to hedge funds would have yielded significantly higher returns from: Jan 2002 until now (multiple market cycles) Aug 2008 until now (Global Financial Crisis) Optimal allocation to hedge funds: The less dependent or correlated the assets, the more the potential gains from diversification Addition of uncorrelated assets with high information ratios results in significant expected return enhancement, thus enhancing portfolio risk-adjusted returns Introduction of alternative strategies improves the portfolio s potential return per unit of risk even at low overall portfolio risk levels (Sharpe ratio) Source: Bloomberg 18
Alternative methods to mean-variance optimization techniques Alternative Methods To Define Optimal Allocations To Alternative Strategies Client-specific customized solutions are designed by minimizing the total (joint) risk of the investor s current portfolio by selecting and allocating across suitable Alternative Strategies Hedge the investor s strategic asset allocation portfolio's principal components Devise flexible customized portfolios of Alternative Strategies, with minimal interdependences with the investor s core portfolio and all of its components Set constraints to provide consistent positive alpha with low downside risks 19
Investors should seek hedge fund managers who have: Deep experience in portfolio management and a culture of continuous innovative research Robust security selection models tested under live performance, historical backtests, and Monte Carlo simulations, covering multiple economic environments Systematic and consistent, yet unconstrained, investment process that applies experience and model analytics to all relevant markets, asset classes, and opportunities Disciplined portfolio construction and downside risk management Flexible modeling capable of meeting specific client needs 20