ASSET MANAGEMENT
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Transcript of ASSET MANAGEMENT
ASSET MANAGEMENTwithin an
ALM FRAMEWORK
Prague, Czech RepublicApril 27, 2007Charles L. Gilbert, FSA, FCIA, CFA
2
Focus on asset returns
Assets managed against benchmark– Asset-only benchmark– Liability-driven benchmark
Investment (i.e. asset-only) objectives specified by client
Beating benchmark and/or achieving investment objectives does not necessarily mean financial objectives will be met
Traditional Asset Management
3
(80,000)
(70,000)
(60,000)
(50,000)
(40,000)
(30,000)
(20,000)
(10,000)
-
2006
2011
2016
2021
2026
2031
2036
2041
2046
2051
2056
2061
2066
2071
2076
2081
Pension Plan Liability Cash Flows
Duration = 15.4 years
Pension liabilities: long-term and uncertain cash flows
4
Asset – Only Asset – Liability
Focus on asset only return / pure asset performanceDoes not capture risk exposureAsset mix determined using efficient frontier
Maximize risk-return trade-off to liabilitiesRisk relative to liabilities more clearly definedRisk to solvency ratios reduced
Liability-Driven Investment (“LDI”) Approaches
Traditional Approach to Pension Investment
Two approaches to managing pension assets
5
Strategic asset allocation and selection of benchmark are the major sources of returns and risk– value added by asset manager against benchmark is lower order of magnitude
Investment strategy loosely recognizes risks associated with pension liabilities– investment objective is to maximize expected return for a given amount of risk– equities viewed as a good hedge against inflation, expected to outperform bonds in the long
term
Traditional approach applied to pensions
6
E[R]
σ
SAA determined using efficient frontier analysis
Minimize risk for a given level of expected return Maximize expected return for a given level of riskBased on expected return, standard deviation and correlation between asset classes
7
Good asset manager can add value vs. benchmark:
Credit quality assessment capabilities based on fundamental analysisTactical asset allocationInterest rate anticipation strategiesOther yield enhancement strategies
Benchmarks selected to manage assets
8
Traditional approach for pensions uses asset-only benchmarkBenchmarks include
– market indices• Lehman Aggregate• S&P500
– peer performance• quartile performance
May include duration targetFocus is on total return of assets irrespective of performance of liabilities
Asset-only benchmarks
9
Benchmark WeightIndex
PerformanceActual
PerformanceAsset Manager
OutperformanceS&P500 60% 10% 11% 1%
Lehman Aggregate (5 yr duration) 40% 5% 6% 1%Portfolio 100% 8% 9% 1%
Liabilities (15 yr duration) 6%
Solvency Ratio 103%
Asset-Only Benchmark Example:No change in interest rates
10
Asset-Only Benchmark Example:Interest rates flatten – long term rates down 1%
Benchmark WeightIndex
PerformanceActual
PerformanceAsset Manager
OutperformanceS&P500 60% 10% 11% 1%
Lehman Aggregate (5 yr duration) 40% 5% 6% 1%Portfolio 100% 8% 9% 1%
Liabilities (15 yr duration) 21%
Solvency Ratio 90%
11
Funding Ratio - S&P 500 Pension Plans
60%
70%
80%
90%
100%
110%
120%
130%
140%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Source: Credit Suisse
Asset-only approach exposed pension plans to significant riskSolvency deficits resulted from falling interest rates and stock prices (so-called “Perfect Storm”)
The perfect storm
12
Pension crisis could have been avoided Asset-only approach focused on achieving high asset returns irrespective of liabilitiesAsset-Liability approach focuses on achieving asset returns that matchreturns of liabilities
1) increase in asset value greater than increase in liabilities and/or2) decrease in asset value less than decrease in liabilities
Liability-Driven Investment framework
13
Liability-Driven Benchmark Example:No change in interest rates
Benchmark WeightIndex
PerformanceActual
PerformanceAsset Manager
OutperformanceS&P500 0% 10% N/A N/A
Replicating Portfolio (15 years) 100% 6% 7% 1%Portfolio 100% 6% 7% 1%
Liabilities (15 yr duration) 6%
Solvency Ratio 101%
14
Liability-Driven Benchmark Example:Interest rates flatten – long term rates down 1%
Benchmark WeightIndex
PerformanceActual
PerformanceAsset Manager
OutperformanceS&P500 0% 10% N/A N/A
Replicating Portfolio (15 years) 100% 21% 22% 1%Portfolio 100% 21% 22% 1%
Liabilities (15 yr duration) 21%
Solvency Ratio 101%
15
Liability-Driven Benchmark plus Beta Example:No change in interest rates / equities +10%
Benchmark WeightIndex
PerformanceActual
PerformanceAsset Manager
OutperformanceS&P500 50% 10% 11% 1%
Duration 30 yr Pooled Fund 50% 6% 7% 1%Portfolio 100% 8% 9% 1%
Liabilities (15 yr duration) 6%
Solvency Ratio 103%
16
Liability-Driven Benchmark plus Beta Example:Interest rates flatten / equities +10%
Benchmark WeightIndex
PerformanceActual
PerformanceAsset Manager
OutperformanceS&P500 50% 10% 11% 1%
Duration 30 yr Pooled Fund 50% 36% 37% 1%Portfolio 100% 23% 24% 1%
Liabilities (15 yr duration) 21%
Solvency Ratio 102%
17
Liability-Driven Benchmark plus Beta Example:No change in interest rates / equities – 10%
Benchmark WeightIndex
PerformanceActual
PerformanceAsset Manager
OutperformanceS&P500 50% -10% -9% 1%
Duration 30 yr Pooled Fund 50% 6% 7% 1%Portfolio 100% -2% -1% 1%
Liabilities (15 yr duration) 6%
Solvency Ratio 93%
18
Liability-Driven Benchmark plus Beta Example:Interest rates flatten / equities – 10%
Benchmark WeightIndex
PerformanceActual
PerformanceAsset Manager
OutperformanceS&P500 50% -10% -9% 1%
Duration 30 yr Pooled Fund 50% 36% 37% 1%Portfolio 100% 13% 14% 1%
Liabilities (15 yr duration) 21%
Solvency Ratio 94%
19
New developments focus on Liability-Driven approach
Greater focus on ALM due to financial lossesGlobal shift to marking-to-market of assets and liabilitiesRegulatory pressure to accelerate funding of deficitsNew instruments enabling effective risk managementMove towards Principles-Based Approaches
20
Liability Cash Flows
(60,000)
(40,000)
(20,000)
-
20,000
40,000
60,000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
2055
2060
2065
2070
2075
2080
Liability Cash Flows
substantial reinvestment rate risk exposure
pre-funding problem
Interest risk remains significant challenge for insurers
21
Replicating Portfolio Benchmark– benchmark is derived as portfolio of zero-coupon bonds that replicates the liabilities– does not work well in practice for long-term liability cash flows
• zero-coupon bonds do not exist at required maturities
Minimum Risk Portfolio Benchmark– benchmark is derived from universe of available instruments that minimizes interest rate risk
exposure– similar to immunization strategy on a specified basis
• dollar duration, effective duration, partial duration, convexity, etc.
Liability-Driven Benchmarks
22
Duration Matched
(200,000)
(100,000)
-
100,000
200,000
300,000
400,00020
06
2011
2016
2021
2026
2031
2036
2041
2046
2051
2056
2061
2066
2071
2076
2081
Asset Cash Flow s Liability Cash Flow s
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Economic surplus exposed to interest rate changes
Asset Cash Flows
Liability Cash Flows
Net Cash Flows
Present Value 1,259,979 1,177,505 82,474 Duration 20.69 20.69 20.71 Dollar Duration 26,073,803 24,365,528 1,708,276 Convexity 520 573 (275)
24
Interest rate risk exposure to non-parallel yield curve shifts
Partial Durations PARTIAL DURATION SENSITIVITY ANALYSISAsset Cash
FlowsLiability Cash
Flows1 month (0.00043) (0.00052) 3 month (0.00222) (0.00218) 6 month (0.01327) (0.00831) 1 year (0.05815) (0.03251) 2 year (0.08661) (0.07642) 3 year (0.27027) (0.19842) 5 year (0.46674) (0.37466) 7 year (0.27681) (0.48408)
10 year (0.43401) (0.52143) 15 year (0.78572) 0.46578 20 year 1.54432 2.23528 25 year 6.34456 2.75792 30 year 15.19911 16.93281 TOTAL 20.69376 20.69327
00 7 35 19 106 145
-222
-69
1532
692
-4716
758
(5,000)
(4,000)
(3,000)
(2,000)
(1,000)
-
1,000
2,000
1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y
15Y
20Y
25Y
30 Y
25
Focus on financial objectives – eliminate “bets” not being fairly compensated for taking– find best risk/reward solution (first optimize on default-free basis)
Assets managed directly against liabilities– eliminates basis risk associated with using a benchmark– aligns portfolio manager incentives – difficult for most asset managers => requires sophisticated techniques– assets no longer separated => performance measurement not simple
No need for client to specify separate investment objectives or try to determine appropriate benchmarkALM drives asset managementGreatest chance of achieving overall financial objectives and reducing risk
Asset Management within ALM Framework
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Overview of ALM implementation
Establish Conceptual Framework
DefineObjectives
AssignRoles &
Respons.
EstablishProcess
CustomizeTools &
Analytics
DevelopRisk
Reporting
SetOrg.
Structure
Identify /Describe
Risks
MeasureRisk
Exposure
DetermineRisk
Limits
BenchmarkCurrent
Practices
BoardApproval
FormulateStrategies
Conduct interviews with Senior Mgt & Key Staff
Get Buy-In / Establish Risk Management Culture
Draft ALM Policy Statement and Procedure Manual
27
Substantial value added through ALM
ALM Framework– ALM conceptual framework defines
• financial objectives, risk tolerances and constraints • how risk is measured• surplus management philosophy
*** Critical to get this right ***– ALM Policy Statement and Procedure Manual– sophisticated tools to manage exposure
Integrated with ERM– framework for strategic decision making– use to achieve financial goals/maximize value
• reduce risks not being compensated for simultaneously increase returns
ALM drives asset management– shift focus from asset returns to overall financial objectives– ensures portfolio manager’s incentives are aligned with company’s financial goals
28
Assets managed directly against liabilities– liability benchmarks replaced with actual liability cash flows– liability-driven benchmarks such as minimum risk portfolio and replicating portfolio
benchmarks are tools used to separate asset performance from ALM performance• can be gamed• absolve portfolio manager from responsibility for overall ALM results• value added against benchmark is incremental by nature
Disciplined process– ALM strategies are formulated to achieve financial objectives– impact of trades on ALM results tested prior to execution
Substantial value added through ALM