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Asset Allocation in a Low Rates Environment

This article discusses the challenges and strategies involved in asset allocation in a low interest rate environment. It explores historical trends, scenario building, expected returns, and the need for a dynamic investment approach. The focus is on adapting investment methodologies and governance to deal with potential outcomes that are difficult to model historically.

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Asset Allocation in a Low Rates Environment

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  1. Asset Allocation in a Low Rates Environment Eric Bissonnier, CFA GIW, INSEAD June 8, 2011

  2. Asset Allocation in a Low Rates Environment • Asset Allocation in a Low Rates Environment • A Brief Look at History • Scenario Building • Expected Returns

  3. Asset Allocation in a Low Rates Environment Asset Allocation in a Low Rates Environment, How Rather than What • We will focus on the process that needs to take place to deal with an potential outcome that is tough to model historically Inflationary environments are ancient -> markets, instruments, asset allocations have changed Post 2008 fear factor, distrust of models and consultants • Investment Methodologies can be made more dynamic… Hedge Funds Overlay • … but the investment pools’ governance requires the largest adjustment

  4. Traditional Asset Allocation and the Reality Traditional Asset Allocation tools rely on some consistency between past and future A stability in asset returns A coherent behaviour (upside/downside) A stable covariance matrix (the past IS the future) Adjustments can be made to work around the model Change expected returns (Risk Premia) Use shorter term data for the asset class correlation Not use the model at all… Asset Allocation in a Low Rates Environment

  5. A Brief Look at History • Asset Allocation in a Low Rates Environment • A Brief Look at History • Scenario Building • Expected Returns

  6. A Brief Look at History: Long Term Changes in Interest Rates

  7. A Brief Look at History: What the Model Sees…

  8. A Brief Look at History: Equity Performance

  9. A Brief Look at History: Changing Correlation Between Bonds and Equities

  10. A Brief Look at History: Average S&P Correlation to so called Diversifiers

  11. A Brief Look at History: The Amazing Regime Change of Correlation Between Equities and Oil

  12. A Brief Look at History: Real Yields have been Well Behaved until Recently

  13. Scenario Building • Asset Allocation in a Low Rates Environment • A Brief Look at History • Scenario Building • Expected Returns

  14. And Now What?? Do we have a Collective Sense of What the Future Holds, Plausibly? Scenario Building

  15. Scenario Building Can you Describe a Scenario? • The “controlled inflation” scenario: • Inflation due to growth; • Monetary action to reduce excess money supply; • Commodity tightening: • What would be the expected return for: • Equities developed; • Equities EM; • Default rates IG and HY; • Cash and Bonds; • Commodities; • Volatility; • Correlation:

  16. Scenario Building • Asset Allocation in a Low Rates Environment • A Brief Look at History • Scenario Building • Expected Returns

  17. Scenario Building EIM Economic Scenario Roadmap Print / Borrow / Spend Model 2010 Current Consensus Fundamental Growth Cycle Forecast Subpar Growth Cycle Drop in Fiscal Income Inflation under control ? Voluntary Exit: anticipating budget constraints Forced Exit: mistrust in ability to repay debt EIM View 20… NO Inflation Growth YES Sustained Growth No Growth Systemic Deflation

  18. Risk Factors Scenario Building

  19. Expected Returns Asset Allocation in a Low Rates Environment A Brief Look at History Scenario Building Expected Returns

  20. Forward-looking Scenario Analysis – Integrated View Expected Returns

  21. Expected Returns Now, What Can we Really do if Yields go Up??The Obvious: • Cash • Short rates go up depending on scenario • Riskiest asset if you have a target return, 100% probability of not reaching return target of Libor +… • Inflation Linked Bonds • May be overbought, i.e. expensive, due to high demand • Buy a bond put warrant from an Investment Bank • When timing is unknown, options are expensive • OTC prices may not be efficient… • Short bonds outright (“delta one”) • Very expensive over time due to negative carry • Risky of yields go down

  22. Expected Returns And the Not so Obvious • Futures based systematic options replication • Such models do not require to get the timing right as the strikes • adapt to “current” market conditions: short OTM 10 year bond put • Futures based breakout models • Liquid systematic exposure to strong trends: short bonds, long Commodities, long commodity currency short developed markets • Long Prepayment Risk in Mortgages

  23. Eric BissonnierE.I.M. S.A.2, Chemin de Chantavril1260 NyonSwitzerlandTel. +41 22 363 64 64 | Fax. +41 22 363 64 65e-mail ebissonnier@eim.chwww.eimgroup.com

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