Strategic Asset Allocation

1. SEACEN Conference December 4-7, 2007 Siem Reap, Cambodia Strategic Asset Allocation Gabriel Petre Investment Officer The World Bank Treasury gpetre@worldbank.org

2. Road map • Importance of strategic asset allocation • Steps in the SAA process • objectives and risk tolerance • eligible asset classes • capital market expectations • constructing the appropriate asset allocation • validation of the SAA • Demo of the Asset Allocation Workbench 2

3. What is Strategic Asset Allocation (SAA)? • “The process by which an institution determines the appropriate neutral asset allocation to achieve its long-term investment objectives” • SAA is neutral (should not be driven by short-term market views) • Objectives are long-term and can be varied (e.g., preserve and grow capital, help meet certain future payment obligations or liabilities etc.) • SAA should be reviewed periodically (conditions can change, both internal and external) • Essentially involves trade-off between return and risk • End-product should be a clearly articulated investment policy statement

4. Sources of risk & return for institutional investors Security or Manager Selection 5% Strategic Asset Allocation 95% Long-term asset allocation is critical for investment success… • Studies by Brinson, Hood & Beebower (1986, 1991) find that strategic asset allocation explains the bulk of the risk of institutional portfolios (over 90%) • Ibbotson & Kaplan (2000) find that almost 100% of the total return of institutional portfolios is explained by the strategic asset allocation (this finding makes sense, since active management is a zero sum game) • Conclusion: in absence of security (or manager) selection skill, investors should spend most of their time, money and effort on strategic asset allocation 4

5. SAA Process 1. Articulate Objectives and Investment Horizon 5. Decide on neutral asset allocation and Implement the SAA 2. Specify Risk Tolerance and Constraints 4. Determine Capital market assumptions (e.g., expected returns) on a forward-looking basis 3. Identify Eligible Asset Classes

6. Typical objectives • Liquidity • What it is • The ability to sell a security and realize cash in a short period without negatively affecting the price; • What it is not • Price volatility (duration) • An accounting concept (securities with unrealized losses) • Capital Preservation • What it is • Constraining the portfolio risks to preserve the principal value of the portfolio over the investment horizon; • Based on market values (mark to market) • What it is not • “Realized losses on a security sold” • Return Generation • What it is • Total return of the portfolio as compensation for a commensurate amount of risk taken on excess reserves • What it is not • Guaranteed outcome on yearly basis

7. Investment Horizon • What it is • Forward-looking period • May vary in direct relationship with the investment objectives • Terminal period and/or interim period • What it is not • Accounting period • How to estimate it • The period over which the investor expects to have the funds with a high degree of probability (reserves adequacy) • Can have multiple investment horizons and tranche the portfolio based on probability of draw-down over these periods • Example • Working capital (30 day horizon) • Investment tranche (12 month horizon) • Long-term tranche (> 12 month horizon)

8. USD Government Bond Returns 1953-2006 Different Risk Parameters for Different Horizons Short measurement periods drive investors into low risk/return strategies

9. Risk tolerance • Risk tolerance is about knowing where the line is drawn between acceptable and unacceptable risks • Need to translate concerns of decision makers into quantifiable statistics (aka risk measure). • Typically expressed as shortfall probability or worst case return at a certain confidence level • Risk tolerance should reflect an institution’s ability to take risk and the current operating environment not a Board’s or individual’s willingness to take risk • Opportunity cost of overly conservative behavior – depending on specific circumstances these costs may be 0.5% - 1% of GDP.

10. Factors that should influence risk tolerance

11. Risk and Return Trade-Off 16.00% 14.00% EM Equities 12.00% 10.00% Private Equity Equities 8.00% Excess Return over Cash Hedge Funds Commodities 6.00% Real Estate Global TIPS 4.00% Fixed Income 2.00% 0.00% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% Standard Deviation Asset classes come in different flavors Asset classes are typically evaluated in terms of risk (measured by volatility) and expected return 11

12. Eligible asset classes: labels don’t tell you the entire story… • Constraining the eligible set of asset classes is not a risk management tool • Combining asset classes efficiently is key Portfolios with varying degrees of equity and UST 1-5 (20% investment grade fixed income) Average Annual Return Worst Annual Return Allocation to Equities

13. Optimal currency composition • Neutral currency or basket of currencies • Liability-driven considerations: • Fixed peg: peg defines the neutral currency • Managed currency: intervention currency • Countries with little or no access to capital market borrowing: trade balance (imports) • Countries with significant but uncertain access to capital market borrowing: short-term debt • Asset-only driven considerations: • Minimum risk portfolio • Views on expected currency returns

14. Currency risk and fixed income • Currencies are very volatile • Currencies have large impact on the risk of fixed income • Additional risk dramatically outweighs the potential added benefit • Most investors hedge fixed income returns back into base currency Currency and asset returns from January 1973 to June 2006. Euro is proxied by Deutsch Mark prior to 1999.

15. Capital market assumptions • Expected returns for each asset class • Historical (full sample or rolling window) • Factor models (regressions or building block) • Predictive regressions (long-horizon regressions) • Building block model for equity returns (earnings growth + dividend yield + P/E expansion or contraction) • Autoregressive models (mean reversion in returns or interest rates) • modeling government bond returns with 3-factor yield curve model • reversion to consensus views, forwards or expected returns implied by asset pricing model • Bayesian models that combine expected returns implied by an asset pricing model with investor views (e.g. Black-Litterman model) 15

16. Capital market assumptions • Volatilities and correlations • Historical • full sample or rolling window • equal weighted or exponentially weighted • Risk factor models • three-factor model for yield curve • Autoregressive models (mean reversion in volatilities) • GARCH models • Regime switching model (asymmetric correlations) • Conditional covariance matrix depending on e.g. bull or bear market regime • Bayesian shrinkage techniques • particularly important when assets included in the analysis are highly correlated 16

17. Portfolio construction • Most common approach employed by institutional investors and asset managers to determine optimal portfolios is mean variance optimization • Mean variance optimization is a procedure that helps an investor find the portfolio that maximizes expected return for a given level of risk (as measured by variance or standard deviation) • Basic philosophy: don’t put all your eggs in one basket! • Key assumption: returns are normally distributed • Inputs: • Expected return of each asset class • Standard deviation of each asset class • Correlation of returns between asset classes • Output: • The efficient frontier, i.e. the set of portfolios with the highest expected return for a given level of risk 17

18. Efficient Frontier • Efficient frontier: set of portfolios which have the lowest possible variance for a given target expected return. Efficient Frontier with risk-free asset Efficient Frontier with no risk-free asset Inefficient Portfolios Expected Total Return Tangency Portfolio Global Minimum Variance Portfolio Risk (variance or standard deviation)

19. The power of diversification Adding lowly correlated assets to a portfolio can significantly reduce the overall risk 9.0% 8.0% 7.0% 6.0% 5.0% Standard Deviation 4.0% 3.0% 2.0% correl = 1 correl = 0.6 1.0% correl = 0.2 correl = 0 0.0% 1 3 4 7 2 5 6 8 9 10 Number of Assets Assumes each asset class has a volatility of 8% and portfolio is equally weighted across each of the asset classes. 19

20. Validation of the strategic asset allocation • Back-testing of models, assumptions, and proposed asset allocation • Robustness checks: compare ex-ante risk limit with ex-post risk of the portfolio • Sensitivity analysis of key parameters • Impact analysis: How much do the portfolio weights change when expected return assumptions or risk assumptions are changed • Marginal analysis: how much does the risk of the portfolio change for a small change in the weight of one of the assets • Stress testing of the portfolio • Forward-looking scenarios: examples include geopolitical unrest/crisis, global recession, rapid unwinding of the US current account deficit, natural disaster (e.g. bird flu) • Historical scenarios: examples include 1992 EMS crisis, 1994 bond market sell-off, 1997/1998 Asian & Russian crisis

21. Implementation of the strategic asset allocation • Implementation of strategic asset allocation • Translation of asset allocation into policy benchmarks • Rebalancing rules (e.g. monthly rebalancing or range rebalancing) • Active or passive management • Risk budget for active management • Policy benchmarks serve various purposes • Reflect the investor’s long-term risk return profile • Yardstick for measuring and attributing the success of any active or passive management • Precondition for effective risk control

22. Review of the SAA decision • What are the factors driving an SAA review? • Internal factors, e.g. major changes in objectives, liquidity situation and liability structure could alter the risk-bearing capacity of the institution • External factors, e.g. changes in market conditions or the market environment (e.g. level of interest-rates) and changes in capital market outlook could alter the risk and return profile of the policy portfolio 22

23. Beware of Noise & Emotions Factor for long-term Strategy Effectof Noise Reduces desire for diversification and risk reduction Diversification Reduces tendency to pay attention to asset/liability matching because of high past performance Goal setting; understanding asset/liability matching Tendency to take too much or too little risk Risk Tolerance Tendency to think short-term instead of long-term Investment Horizon Tendency to abandon set strategy because of events Discipline 23

24. Tools to assist asset allocators • Limited number of professional tools available for asset allocation • Typical solution: use Excel spreadsheets • Advantage: simple and relatively easy to learn • Disadvantage: not robust, hard to revise when new data becomes available, not easy to share with colleagues • Need a more robust and professional solution

25. Asset allocation workbench • TRE asset allocation team developed the Asset Allocation Workbench • based on models and procedures developed in-house • consolidation of various ‘Excel’ spreadsheets and Matlab functions • one data repository • used for asset allocation work for internal clients • Core modules in the workbench: • Data manager • Asset return generator • Optimizer • Backtester

26. Suite of tools developed by TRE Asset Allocation team

27. This presentation has been prepared by the Treasury of IBRD (TRE) for working purposes for the clients participating in RAMP program to guide them in understanding certain concepts underlying investment management. It does not represent, and shall not be interpreted as specific advice or recommendation as to any particular matter covered herein, nor as an indication of market standard in a particular area. Nothing contained in the presentation constitutes or shall be construed as a representation or warranty by IBRD. The Client acknowledges that this presentation is a proprietary document of IBRD and by receipt hereof agrees to treat it as confidential and not disclose it, or permit disclosure of it, to third parties without prior written consent of IBRD.

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