STRATEGIC ASSET ALLOCATION

1. STRATEGIC ASSET ALLOCATION James Thompson Government Actuary’s Department United Kingdom

2. What is strategic asset allocation? The efficient optimisation of investment allocation to major asset classes of investment in order: - to meet the overall investment objectives of the institution and - to achieve an acceptable balance between risk and return

3. As opposed to tactical investment selection • Tactical investment selection is the choice of individual investments in line with the chosen strategy • Both strategic and tactical decisions are important • But the strategy will often be the more significant determinant of performance

4. Purpose of investment • allow liabilities to be met as they fall due • liquidity • matching • aim to produce good return to minimise cost of benefits (or increase benefit levels) • control risks - diversification • provide security for members’ benefits • stabilise contribution rate

5. Also …. • provide source of government funding • provide finance for specific government investment projects or to further government policy • develop capital markets

6. General principles • assets should be appropriate to the liabilities • diversification is needed to reduce risk… • …between asset classes and within classes • trade-off of risk and return • correlations of risks and returns

7. Classical asset allocation theory • optimisation of risk and return (Markowitz) • there is a wide spectrum of possible portfolios • rational investors select strategy on frontier… • …to maximise return for given level of risk… • …or to minimise risk for given level of return • combine portfolio with risk-free assets to reflect acceptable level of risk • assumes asset returns are known and normally distributed

8. Efficient frontier 5% 4% 3% 2% 1% 0 B A C Mean Rate of Return 0 1% 2% 3% 4% 5% 6% 7% Variance of Return

9. However this approach is simplistic • returns are not normally distributed and variance is not the only measure of risk • the returns, variances and correlations are not known, and may change over time • does not have regard to the liabilities

10. Liabilities • investments aim to allow the liabilities to be met • some more uncertain than others • promise to pensions or other cash benefits in future • promise to provide non-cash benefits such as healthcare • contingent liabilities, including catastrophe and fluctuation reserves

11. Nature of liabilities • identify the liabilities to which the investments relate • amount and timing • nominal or related to inflation • currency • degree of uncertainty in amount and timing • possible embedded options

12. Possible investments • depends on market • government bonds • corporate bonds • index-linked bonds • bank deposits • equity shares • real estate • derivatives

13. Also … • mortgage loans • government projects • works of art • precious metals • commodities

14. Nature of investments • amount and timing of cashflows • nominal or linked to inflation • marketability/liquidity • volatility of value • default risk

15. Other factors • diversification • accountability mechanism • political interference • social security legislation • impact on stakeholders • regulation • expertise • expenses

16. Matching the assets and liabilities • matching involves investing in instruments whose value will behave in a similar way to the value of the liabilities in varying financial conditions • if absolute matching, no future changes in conditions would affect the ability to meet the liabilities • in practice, matching will never be absolute • matching may be low risk, but may be expensive if the matching assets have low returns

17. Example of matching • there may be a liability to pay pensions, increasing in line with prices, to an existing group of pensioners • the pensions in effect represent a stream of payments linked to prices over the next 30 years or so • index-linked government bonds also represent a stream payments linked to prices • hence matching could be achieved by investing in a portfolio of index-linked bonds whose duration was similar to that of the pensions

18. Behaviour of matched portfolio

19. Example of matching • in practice, the position may be much more complicated than this • liabilities will also relate to current workers and their benefits may therefore depend on wage as well as price inflation • the scheme may be only partially funded raising the question of which liabilities are funded and can be matched • future contributions might be regarded offsetting future payments but this adds further uncertainty

20. Asset-liability modelling • determine the measure to be controlled by the investment policy, e.g. the funding level (assets as a percentage of liabilities) or contribution rate • stochastically project liabilities and assets • many different investment models and parameters which will produce differing results • compare results from different strategic asset allocations

21. Funding level after 15 years 4 3.5 3 90% 75% 50% 25% 10% Upper Decile 2.5 2 Upper Quartile Ratio of Assets to Liabilities 1.5 Median 1 Lower Quartile Lower Decile 0.5 0 A B C D Portfolio

22. Suitability of asset classes • Cash and short-term deposits • usually low risk and low return • useful for liquidity (e.g. for a working balance and fluctuation reserves) • not generally appropriate for longer duration liabilities except as a short-term tactical measure

23. Suitability of asset classes • Government bonds • a variety of terms means they are often useful as matches for certain liabilities • longer-term bonds can be vulnerable to high inflation and therefore index-linked bonds may be preferred if liabilities are inflation linked • may be relatively marketable, although this will depend on the country concerned • generally low risk and low return

24. Suitability of asset classes • Corporate bonds • similar to government bonds but less secure (and consequently higher return) • risk will vary according to the issuer and may change during the course of the investment • market for corporate bonds usually less broad and less liquid than that for government bonds • will be affected by wider economic sentiment and may therefore have depressed values at precisely the time they are needed (e.g. in a recession)

25. Suitability of asset classes • Equities • more risk and higher expected returns than bonds • historically have produced considerably higher returns than bonds • returns should be linked to future economic fortunes of the country • however, the value of equities can vary very widely in the short and long-term • high levels of equity investment may lead to issues of government control and indirect nationalisation • market in equities may be limited or non-existent in some countries

26. Suitability of asset classes • Foreign investment • useful in order to diversify • can take advantage of investments not available in the domestic market • may introduce currency mis-matches which can be mitigated by suitable hedging • central banks may be concerned over possible adverse currency flows • tax may be levied in foreign countries

27. Suitability of asset classes • Real estate • some features of bonds and equities • generally illiquid and expenses of managing such investments can be high • investment in domestic property (houses) may be sensitive and prone to political interference

28. Benchmarking • set a benchmark against which to measure performance • benchmark might be a low risk matching portfolio… • …or perhaps an index or combination thereof • effect of deviating from the benchmark can be measured • is the extra return worth the risk?