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STRATEGIC ASSET ALLOCATION. James Thompson Government Actuary’s Department United Kingdom. What is strategic asset allocation?. The efficient optimisation of investment allocation to major asset classes of investment in order:

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strategic asset allocation

STRATEGIC ASSET ALLOCATION

James Thompson

Government Actuary’s Department

United Kingdom

what is strategic asset allocation
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

as opposed to tactical investment selection
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
purpose of investment
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
slide5
Also ….
  • provide source of government funding
  • provide finance for specific government investment projects or to further government policy
  • develop capital markets
general principles
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
classical asset allocation theory
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
slide8

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

however this approach is simplistic
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
liabilities
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
nature of liabilities
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
possible investments
Possible investments
  • depends on market
  • government bonds
  • corporate bonds
  • index-linked bonds
  • bank deposits
  • equity shares
  • real estate
  • derivatives
slide13
Also …
  • mortgage loans
  • government projects
  • works of art
  • precious metals
  • commodities
nature of investments
Nature of investments
  • amount and timing of cashflows
  • nominal or linked to inflation
  • marketability/liquidity
  • volatility of value
  • default risk
other factors
Other factors
  • diversification
  • accountability mechanism
  • political interference
  • social security legislation
  • impact on stakeholders
  • regulation
  • expertise
  • expenses
matching the assets and liabilities
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
example of matching
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
example of matching19
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
asset liability modelling
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
slide21

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

suitability of asset classes
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
suitability of asset classes23
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
suitability of asset classes24
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)
suitability of asset classes25
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
suitability of asset classes26
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
suitability of asset classes27
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
benchmarking
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?