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Overview

Senior Management Programme in Banking Module IV: Asset Management Professor Andrew Clare Cass Business School October 2012. Strategic asset allocation Tactical asset allocation The tactical asset allocation game Alternative investments – how alternative are they? Liability driven investment

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Overview

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  1. Senior Management Programme in BankingModule IV: Asset ManagementProfessor Andrew ClareCass Business SchoolOctober 2012

  2. Strategic asset allocation Tactical asset allocation The tactical asset allocation game Alternative investments – how alternative are they? Liability driven investment Alpha – what value do active fund managers add? Choosing a fund manager Investment strategies – simple strategies for generating alpha Overview

  3. Strategic asset allocation Professor Andrew Clare

  4. Asset allocation: what’s it all about Long-term expected returns Risk premia Expected risk & risk aversion Appendix: Yale university's endowment fund Overview

  5. Emphasis on broad asset categories: Equities, Bonds, Property, Currencies etc US v UK equities etc Main Practitioners: Life Companies Pension Funds Funds of funds Family offices Asset allocation Page 4

  6. 100000 10000 UK equity Gilts T - Bills Real indices, logarithmic scale 1000 100 10 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 A historic perspective on asset allocation Its simple: just buy equities !!! Page 5

  7. Long-term asset holdings of UK’s DB industry But most institutional investors do not hold only equities. Page 6

  8. Strategic refers to longer-term outlook, bedrock of investment goals Defining a benchmark for tactical asset allocation Getting it wrong can be very costly Should the aim be to maximise expected return, or maximise expected return, while simultaneously seeking to minimise expected risk ? Strategic asset allocation Page 7

  9. Often asset allocators make use of the MV framework But to do so we need to know: expected returns, variances and covariances to construct the frontier Using the MVE framework A mean-variance frontier for asset classes Page 8

  10. Long-term expected returns

  11. Historic returns could be misleading – over the last ten years the FTSE-100 has fallen !!! So asset allocators try to take a forward-looking view. We will try to do the same and apply this view to: Cash Government bonds Corporate bonds Equity Determining expected returns Page 10

  12. There are three components of expected return on all assets Ex ante real return Compensation for future inflation Compensation for risk Let’s begin by determining the “neutral rate”, which comprises the first two components Long-term expected return components Page 11

  13. In a world with no inflation and no risk, investors would still require a return from their investments, but how much ? It would depend upon the ‘opportunity cost’ of foregone consumption It’s closely related to the potential growth rate of the real economy The ex ante real return Page 12

  14. Average real GDP growth since 1970 Average annual, real GDP growth since 1970 Long-run economic growth low: ex ante real return should be low too Page 13

  15. Despite many new inventions - railways, telephones, microchip, the internet etc - economic growth has actually been remarkably stable Perhaps then historic GDP growth will be a good guide to long term future real GDP growth On the other hand, is the credit crunch a paradigm shifting event … the end of capitalism as we know it ? Such estimates probably a good proxy for the long term ex ante real return Yields on long-dated index-linked gilt market can give us a clue to what the market thinks about trend growth The ex ante real return Page 14

  16. Yields on long-dated index-linked gilt Real, long term govt bond yield (UK) UK’s real long-term economic growth (was) similar to index-linked bond yield Page 15

  17. Yields on long-dated index-linked bonds Short term real yields (pre-crisis) Short term real yields (post-crisis) There’s clearly more to default-free real yields Page 16

  18. Inflation expectations affect the nominal expected return on assets How does one go about forecasting inflation ? Compensation for future inflation Page 17

  19. The recent low inflation environment Inflation in a selection of developed economies since 1960 Source: Thomson Financial Will the low inflation environment stick this time? Page 18

  20. 60 50 40 Number of inflation targeting central banks 30 20 10 0 1970s 1980s 1990 1991 1992 1993 1994 1995 1996 1997 1998 Inflation targeting Inflation targeting: the 1990’s epedemic Source: Bank of England Inflation targeting has had a big impact upon the inflation environment Page 19

  21. Inflation targeting Inflation targets in a selection of developed economies • Most seem to target between 2 to 3% • Why not target 10% or 0% ? Page 20

  22. Market “inflation expectations” Are market inflation expectations consistent with targets ? Break evens over time Ten-year break evens Page 21

  23. In the UK it seemed reasonable in the past to assume inflation of around 2.0% (CPI), that is, 2.5% (RPI). But what about now ? In Europe 2.0% In USA – the Fed have just launched QE3 – an indefinite commitment to expand the money supply Today, arguably, the inflation picture hasn’t been this uncertain for some time Compensation for future inflation Page 22

  24. Putting together an estimate of trend growth and expected inflation gives a neutral policy rate for an economy Neutral rate will be close to expected return on cash For the UK prior to the credit crunch it might have been: 2.25% for growth 2.5% (RPI) for inflation Giving a grand total of 4.75% But what about now ? Putting it all together: an example Page 23

  25. Policy rates will cycle around their ‘neutral rates’ The return on cash will be closely related These neutral rates can change themselves if: trend growth changes (productivity improvements, labour migration, credit crunch) monetary policy regime changes The return on cash is the basis for future expected returns on all assets The risk premium is what distinguishes them The ‘neutral rate’ Page 24

  26. Pre and post crisis policy rates Policy rates in Jun ’07 and Dec ‘11 Page 25

  27. Risk premia

  28. Why do we want to be compensated for bearing risk ? Risk inherent in investment classes distinguishes expected returns Measuring risk premia is very problematic Risk premia Page 27

  29. Government bonds – an ‘inflation risk premium’ Corporate bonds – a credit risk premium Equities – the equity risk premium Risk premia on main asset classes Page 28

  30. Biggest risk in holding conventional, govt bonds is inflation In past governments have arguably “inflated away” their debts – they may be tempted to do this again Investors demand an additional return, mainly because future inflation is uncertain (other risks too) It will depend upon the: the monetary policy framework and the credibility of monetary authorities The “inflation risk premium” Page 29

  31. Yield on Conventional government bond (Gilt) Minus Yield on index-linked government bond (ILG) Minus Estimate of expected inflation (survey based) Equals Measure of inflation risk premium Calculating an “inflation risk premium” This gives a good proxy for the risk premium on government bonds Page 30

  32. Australia Canada France Italy Japan UK USA 0.0% -0.5% -1.0% Change in bond risk premia, %pa -1.5% -2.0% -2.5% -3.0% Inflation risk premia Measure of the inflation risk premium for gilts Change in BRP (2007-2011) It’s fallen everywhere, but not because of receding fears of inflation Page 31

  33. Government bonds – an inflation risk premium = 0.50% to 1.00% ? Corporate bonds – a credit risk premium Equities – the equity risk premium Risk premia on main asset classes Page 32

  34. Credit premium additional return over equivalent govt bond to compensate for credit risk Varies according to the type of firm (AAA, AA, A, BBB etc) Outside US not much history to guide us as to likely future credit risk premium It’s also very volatile … The credit risk premium Page 33

  35. Credit premium varies over time The credit risk premia 34

  36. Credit premium varies by rating 35

  37. Credit premium varies by sector 36

  38. Company specific factors • Company fundamentals play an important part in the premium too 37

  39. Risk neutrality and the credit premium • However, if investors are risk neutral then they will only asked to be compensated for the potential additional loss compared with a default-free investment • What we expect to lose from investing in a credit risky entity is simply the product of the probability of experiencing and the scale of that potential loss Expected loss = probability of loss x (1 – recovery rate) 38

  40. The probability of loss (1920-2008) 39

  41. Recovery rates – (rating 5 years before default) 40

  42. The “risk neutral” credit premium • Credit premium = prob. of loss x (1 – recovery rate) • For example: • Expected loss rate for Baa over ten years = 5% x 40% = 2% • Or something like that • The degree to which the actual spread differs from the risk neutral, or ‘fair’ spread reflects the additional return required by risk averse investors 41

  43. Loss rates (1982-2008) 42

  44. Government bonds – an inflation risk premium = 0.25% to 0.50% Corporate bonds – a credit risk premium, the starting point should be the historic loss rate, let’s say = 1.50% to 2.00% for Baa Equities – the equity risk premium Risk premia on main asset classes Page 43

  45. ERP is the additional return required over long-dated government bond for bearing equity risk But what is equity risk ? profitability ongoing viability of company The equity risk premium Page 44

  46. Equities are a poor hedge against recessions UK real equity returns Historic equity risk premia Page 45

  47. The Dividend Discount Model (DDM) • When we buy equities we purchase a future stream of dividends • All we need to do is calculate the “present value” of each of these dividends and add them all up • But • dividends are paid over a long period • and are uncertain • However, if we assume that they grow at a constant growth rate, maths can help us out … Page 46

  48. The Dividend Discount Model (DDM) ERP +Risk free rate = Dividend Yield + Dividend growth or ERP = Dividend Yield + Dividend growth  Risk free rate • Dividend yield can be observed • Risk free rate can be observed (government bond yield) • Dividend growth – unobservable • If we apply some macroeconomic theory then we can arrive at a very simple measure of the equity risk premium … Page 47

  49. Simplifying the DDM ERP = Dividend Yield + Growth in dividends  Risk free rate • if dividends grow in line with real economy over long periods of time and • if real risk free rate is close to trend growth of the economy then (for the UK): ERP = Dividend Yield + 2.25%  2.25% ERP = Dividend Yield Page 48

  50. 12.0 10.0 8.0 Implied equity risk premium, % pa 6.0 4.0 2.0 0.0 1965 1970 1975 1980 1985 1990 1995 2000 2005 UK’s equity risk premium A measure of the UK’s equity risk premium In 1970s required additional compensation was high Page 49

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